Friday, September 08, 2006

Win Ben Stein's Ire

smug portrait As a rule, I usually don't spend a lot of time on reader mail, or on the analysis of it here in these pages.  It always feels self-serving to wax poetic at audience response to one's writing.  For the same reason I don't turn comments on for the entries here.  (A few readers have asked me to, and sometimes I actually consider it).  Recently, however, reader mail has been interesting and insightful enough to warrant more comment.  The three recent posts that have gotten me the most reader interest (as measured by influx of mail) here at Going Private include:

1.  Imminent Death of Private Equity Predicted,
2.  Nicole Kidman Should Run a Hedge Fund, and;
3.  Voodoo Economics.

The majority of replies to "Voodoo Economics," my critique of the piece in last Sunday's New York Times on the evils of management buyouts by econ guru, general figure of shareholder menace and sometime economics teacher actor, Ben Stein, began with some version of:

"Ben Stein is off his rocker, but..."

...and continued to suggest that MBOs really ARE evil, though not for the reasons Mr. (Professor?) Stein would indicate.  My favorite in this vein is, by far, the opening penned by a fellow practitioner.  Specifically:

"While I agree that Ben Stein's butter seems to have slipped off his pancakes..."

I have to say I admire the structural consistency many of Going Private's valued readers display in writing comments to the editor.  The next phase of almost every Ben Stein letter was triggered by prose generally resembling:

"I think you're misinterpreting Stein's [noun]", or;
"Your critique fails to account for [shopping list of items]."

Here are some of the arguments Going Private readers made in defense of Professor Stein:

1.  My critique relies on the existence of "efficient markets" in the philosophical sense.  In other words, my argument falls apart if markets are not perfectly efficient in the economic theory sense.

I'm not sure where this criticism comes from as I thought I pretty clearly explained how one's theory of market efficiency was not operative on the question of MBOs except as to define if "inside information" could actually benefit an insider.  (Proponents of "perfectly efficient" market theory would be hard pressed to show how inside information could be helpful to an insider).  The question is not "are markets fair" it is "are shareholders oppressed by MBOs" compared to other transactions.  A lot can be gleaned from simple resort to comparison between LBOs (to which Stein seems to have less objection) and MBOs.

2.  There is some fundamental unfairness intrinsic to MBOs with respect to shareholders.

I was struck by the similarity of some commentators objections to the attitudes that caused me to pen "Beware Dark Figures Bearing Fairness."  We should all know that in markets, as in life, fairness is a relative, subjective and therefore dangerous term.  Oddly, the trend in the United States seems to be in the other direction, towards an entitlement to returns.

I suspect that the creeping entitlement to "market returns" that has begun to rear its ugly head is, to no small degree, fostered by the increasing linkage of high market returns to defined benefit (as opposed to defined contribution) retirement plans.  The issue is framed nicely in a recent Wall Street Journal opinion piece by McMahon, a senior fellow at the Manhattan Institute:

Public funds, however, are allowed to discount their long-term liabilities based on the assumed annual rate of return on their assets-- which, for most public funds, is pegged at an optimistic 8% or more. In other words, the risk premium in the investment target is compounded in the liability estimate. (This accounting twist also explains how politicians can claim, with straight faces, that pension obligation bonds are a nifty arbitrage play.)

If the liabilities of public pension funds were valued on the same basis as private funds -- using, for example, the 30-year municipal bond rate as the discount rate -- funding requirements would be dramatically higher. Estimates of the nation's real public pension funding shortfall range from an added $500 billion for state retirement systems to at least $1 trillion for all public systems.

The 8% rate of return assumption, while shared by some major corporate plans, is certainly open to question. But public pension fund managers are in a pickle: If assumed returns were reduced, even "fully funded" systems like New York's would find themselves tens of billions in the hole -- as shown by alternative calculations buried in financial reports for Gotham's retirement systems. And so, in the name of protecting taxpayers from having to pay higher contributions in the short term, funds expose them to more volatility and risk over the long term.

Public pension funds used to be run on more of an insurance model, heavily reliant on fixed-income securities. But over the past 40 years, the vast expansion of government at every level has vastly expanded the pool of public pension liabilities. This leads to a vicious cycle: As the employee head count rises and unions lobby for bigger pension entitlements, funds feel pressure to pursue riskier investments with higher returns -- which explains their increasing reliance on stocks, as shown in the nearby chart. But when returns exceed expectations, as in the boom market of the 1990s, politicians and fund trustees feel irresistible pressure to raise benefits again.

Not surprising then, the news that pulling an 8.5% return on a $10+ billion portfolio gets you fired in this day and age.  High returns have become an inalienable right.

I have also wondered to myself what a 1920s era Lloyd's broker would think if teleported to the year 2006 where auto insurance is mandatory in some U.S. states and somehow health care insurance has become a "right."  Same issue.  A "right" to a financial return.  Something for nothing.

We should all know better than to believe that regulation can "level the playing field."  I would love to be able to run as fast as Carl Lewis.  Too bad for me.  There ought to be a law!

I was surprised, therefore, then to find most of the pro-Stein arguments bearing some version of this "fairness" argument.  That the poor shareholders were being fleeced somehow by clever management.  That they were being deprived of returns that were rightfully theirs.  Returns that they "already owned" somehow, even though these returns have yet to materialize.  Arbitrage opportunities that were "rightfully theirs" in the words of one email contributor.

It is this attitude that permits market actors to indulge themselves with fantasies that returns that they themselves are in no position to create or realize, or returns that are not possible without substantial changes in the financial environment, perhaps even returns that they had expected when they bought the stock in the first place, are theirs to capture (even before they have been earned).  This attitude, I believe, is what prompts writers like Stein to decry managers in a position to create returns when taking private a firm that the very shareholders now complaining made impossible to realize in the public capital markets in the first place though behaviors as varied as the fixation on short-term (quarterly) earnings prospects, poison pill arrangements, and pricing the company's stock below book value because of an aversion to risk.

"But you are ignoring the vast information disparity between managers and shareholders," worried one commentator.  (The same commentator that only two paragraphs earlier had insisted that markets were perfectly efficient.  My question as to how the managers could capitalize on "superior information" in a perfectly efficient market went unanswered).

Even in an inefficient market (and I don't believe U.S. capital markets are perfectly efficient) superior information only gets you so far.  And in the United States there are any number of safeguards to prevent abuses here.  Ex ante there is the shareholder vote and board approval requirements.  Ex post there is a long and studied history of shareholder litigation over items like price and deal terms.

"They are sharing non-public information with potential buyers and showing favoritism in picking which buyers to share that information with."

Let's pretend for a moment that this is true.  The redress for this is in Rule 10(b)(5), not in the outright ban of MBO transactions as Stein suggests.  The disclosure of material non-public information to a potential buyer to the exclusion of others falls into the insider trading realm.  Woe to the buyer who continues to bid in such a circumstance.

Shareholders are hypocritical here quite often.  Insisting on full disclosure when "good news" might give them an upside, but quite happy for information to be secret and markets mispriced upwards when they are selling.  In reality, shareholders like Stein don't care if markets are mispriced, they just don't want to be on the wrong side of the mispricing.

"But poor shareholders can be victimized by the tyranny of the majority, even if they didn't want to sell," said one writer.

I am unsympathetic.  Shareholders knew or should have known when they bought the stock that they were subject to the possibility of a MBO (or any M&A transaction) where they would be on the losing side of a Board of Directors decision or proxy fight.  That is "the deal."  One wouldn't expect to be taken seriously if one's political candidate lost an election and one was moved to complain "I should have two votes!  It is not fair that I lost and the voting rules I knew about before the election should be modified retroactively to permit my victory!"  Strange then that this argument is constantly being forwarded in the context of shareholder actions.

Another reader points out something insidiously clever.  Stein, he quips, is outraged at exactly the behavior he, himself, is exhibiting.  Stein bought the stock in the first place convinced that he knew better than other shareholders how to extract value from the stock or that a price disparity would benefit him.  Superior knowledge, therefore, is what Stein wants to profit from.  How then can he, with a straight face, complain when management does the same via an MBO and most shareholders willingly sell?  Stein is entirely free to start an activist fund to do the same, if he can garner the capital.  Should we ban all transactions where homework, good sense and a lot of research give one participant an advantage?  This same reader points out that Stein's argument is "so eerily similar to an argument recently put forth in the 8/28 New Yorker."

Another reader wondered if how these transactions could be fair given that management had all upside risk and no downside risk.  I can't speak for that reader's experience, but I haven't seen an MBO where management didn't have substantial personal net worth at risk.  Sub Rosa has done 4 MBOs since I arrived. All of them contain provisions (like co-investment) that would put the senior managers in the poor house if the deal blows up.  This is not an accident.  We do it, as do other private equity firms, for precisely these incentive reasons.  While not my favorite example of excellence in financial journalism, a recent article in Fortune on the decision of former GE Vice Chairman Dave Calhoon to head up VNU when opportunities in much larger, public firms were available demonstrates this point nicely.  Says Fortune:

Press reports valued his pay package at around $100 million, but its real value is uncertain because Calhoun is also making a substantial investment in VNU (no one is saying exactly how much).


The most interesting question arising from this situation is: Why couldn't a huge publicly traded company make Dave Calhoun an offer he'd accept, but a small privately held firm could? Again, the answer seems obvious. In today's climate of deep shareholder distrust, no public company would dare to offer a prospective boss such munificent terms.


Any public company that now offered a new CEO $100 million would be scourged without mercy by shareholder activists and TV talking heads nationwide.

And as to the question of "skin in the game," and sweetheart deals to management?

Calhoun is as sharp as anyone, and he was negotiating against people representing the Blackstone Group, the Carlyle Group, Kohlberg Kravis Roberts, and the other private-equity firms that bought VNU - collectively the smartest, toughest SOBs in business. Whatever deal they reached is the correct deal because it represents the market at its most efficient, ruthless best. Calhoun stands to make $100 million or more because cold-eyed investors with their own money at stake believe he's worth it.

Increasingly, public capital markets are beginning to look like the laws of thermodynamics (You can't win; you can't break even; you can't get out of the game) with Vegetable Capital actors playing the part of the universe and getting the free lunch.  Managers increasingly are faced with reduced compensation for more risk.  When they do profit it is called "windfall."  Responding totally rationally to this perverse set of incentives, they choose to leave the public markets and, in doing so, find themselves under attack from the likes of Ben Stein, who feels he has been cheated because they didn't sit around and "do what they were supposed to do in the first place," i.e. make money for shareholders while taking less and less pay and adopting more and more personal legal and financial risks and incurring increasing opportunity costs.

Why does this increasingly feel to me like the plot for an Ayn Rand novel?

Tuesday, September 26, 2006

Fading Amaranth

a reminder that risk actually means risk I was fortunate enough to know several professionals at Amaranth.  I say "fortunate" because they were quite pleasent to work with and knew their stuff.  I say "was" because they don't answer my calls now.  It would be a simple task to join the hoards crowing over the quasi-fall of the fund, but there is a deeper lesson here, and I don't want to neglect it.  Abnormal Returns touches on it today by referencing, in true Abnormal fashion, an entirely different and entirely similar discipline.  Cooking.  Says Abnormal Returns, citing Bill Buford in the New Yorker:

Tim Zagat, the publisher of Zagat Guides, points out that for more than two decades the cost of going to restaurants or getting takeout has risen less than the annual rate of inflation—that it’s much less expensive today than at any other moment in our history to pay other people to prepare our dinner. Never in our history as a species have we been so ignorant about our food.

Abnormal Returns then comments:

Let’s take a minute and think about the world of investing today. At no time in history has it been easier or cheaper to assemble a low cost, indexed, globally diversified portfolio. (This is one of the great accomplishments of the ETF revolution.) The vast majority of investors would be well-served in this approach. However the majority of the media reaching investors serves to tell an entirely different story.

From CNBC, to infomercials to brokerage ads we are constantly bombarded with the notion that investment success is simply a click away.  Any one who has read this blog for any period of time knows that we are in the camp that active investing is far from easy, indeed active investing is, in fact, hard.  That should not deter an individual from pursuing investment expertise, but they should do so with their eyes wide open.

This analogy is a deft one, I think.  Short of the not yet revealed revelation that Amaranth deviated from its investment strategy as defined in its placement memorandum, or that it timed the disclosure of its massive losses to avoid a run on the September 18th deadline for October 31st redemption requests, I find it difficult to point fingers at Amaranth.

I have commented before in these pages on the slow, but sure, creep towards an entitlement to returns in the United States.  As if everyone were somehow possessed of the right to above market returns (or even market returns) and anyone who interfered must be arrested, sued, imprisoned or sent into exile.  An ignorance about the trade off between risk and return is, I suspect, at the heart of these sorts of delusions.  The kind of world view, one that believes that we can apply the laws of thermodynamics to market actors (can't win, can't break even, can't get out of the game) and thereby extract better than market returns from them at no risk to ourselves, seems increasingly acceptable.  (Ignoring for the moment that it is the market actor we box in that is expected to pay).

This is the formula that prompts legislators and other demagogues to propose "windfall profit taxes," "poison pills," restrictions on LBOs and causes people to expect that a fund like Amaranth can return 20%+ returns year in and year out without taking the kinds of risks that may, surprise, surprise, blow it up.

It is interesting to me the sort of double standard we apply to these kinds of melt-downs.  Take such risks and lose and the Wall Street Journal might cite industry experts with: "To have a relative newcomer… receive so much discretion is just shocking to me."  But at the same time we all worship the general who fights against impossible odds and wins.  We cheer for the quarterback to completes the impossible pass.  We love risk, when we win.  We condemn it, when we lose.  Half a dozen traders happily piped in with an "I told you they were reckless!" but no one, least of all investors, seems to remember actually being told that until now.

Despite this, it does surprise me that Amaranth bet "half the farm" on one man's game, and it is quite illustrative that Abnormal Returns would run down a New York Times piece (avoid irritating registration via bugmenot) pointing out that there doesn't seem to be a single big winner (or three) on "the other side of the trade," or another firm that took a career-ending injury loss.  Amaranth was truly out in the cold on this bet.

Be that as it may I think we need to start to remember what risk/reward is.  Particularly as we begin to grapple with the entirely unreasonable expectations that have been heaped on, among other areas, the world of retirement finance by the many blind Barons of Short Termernia.  Ignorance in this area, after all, can be lethal.

Thursday, November 30, 2006

Private Equity, Private Lies

the real friedman? With Milton Friedman dead what else would we expect to but encounter all manner of schemes now afoot to defuse the market.  The scene suggests the death of a long-hated and aged dictator after a long illness or quick coup, given the number of parties vying for thought leadership and the demagogy involved.  I suppose that would equate the subject of the latest round, management buyouts, to Italian fascism.  Andrew Ross Sorkin seems to have jumped onto the bandwagon Ben Stein has been piloting in this capacity.  Michael Kinsley of seems to have been relegated to the position of navigator, though given the position he recently penned for Slate on capitalism he should perhaps be sitting way out on the left wing.  Sorkin outlined his own four point plan to make management buyouts "fair" again.  I am reminded of the communists emerging once again, dusty faced, but bright eyed, from the ruins of Stalingrad, emboldened by the receding shadows of vanquished fascism.  You will see, I think, that the communists have always proved much better propagandists than the fascists.  Their lies are far more enticing as they are wrapped in the cloak of populism and contrasted to fascism's intrinsic elitist strain.  The reality is that communism is centered around its own elitism, it is just far more adroitly camouflaged.  Either way you go, you can smell the sickly sweet stench of lies.

Loyal Going Private readers will already be aware of my feelings about the word "fair," but for the uninitiated, it seems pretty clear to me that whenever someone calls for change to make things "fair," what they usually mean is that they plan to take someone else's hard work and hand it out to someone who hasn't gotten their hands dirty yet- in the interest of "fairness," you understand.

Sorkin begins:

Management led buyouts, by their very nature, are meant to benefit management and their private equity backers,” Stephen Lowey, a lawyer who often represents institutional investors, said to me last week.

No?  You mean they aren't meant to benefit starving African children?  Who knew?  Hard not to point out that Sorkin's foot dips into the water this way- with the assumption that these transactions are presumptively zero-sum games- and that this is somewhat concerning.  Just wait, dear readers.  Just wait.

The trip continues:

He contended that public investors almost always get cheated, and it’s not hard to see what he’s talking about. Every day, it seems, some stock that has been battered is being picked off by its own management and private equity firms at a paltry premium.

Watch carefully, this is the magic that is at the root of all these anti-MBO arguments, be they Steinisms or Sorkinettes.  Did you catch it?  It was a pretty quick slight of hand there, but it only took twenty words or so to point to an asset that is being traded in one of the most liquid and efficient markets on the planet and claim that it has been mispriced.  And this, dear readers, is the conceit at the heart of these arguments.  That we have to protect the market from itself.  That the very shareholders who have bid the company down need to be protected from the pricing action they, themselves created, by preventing interested parties from buying the asset at the quoted price.  You see, it's really worth more.  Damn the market, full speed ahead!

And even that isn't the whole story, as apparently these same shareholders deserve a premium.  Not just a "paltry premium," mind you, but a substantial premium.  Let's ignore for a moment that this would have the effect of rewarding the kind of short-term speculation that hangs on every fraction of a penny in earnings for this quarter to determine if the stock should be battered or not.

What we have quickly said here, is that because someone might, possibly, benefit in future, albeit at greater risk, and despite the fact that the shareholders as a whole don't see the value (if they did why is the stock price so depressed) we cannot possibly allow third parties to pay above market price for a company, undertake a risky (to themselves) plan to improve value and put their own reputation and capital on the line to do it.  In the interests of fairness, they need to share those "windfalls."  Please.  Where is Muffie Benson-Perella when you need her?

I cannot imagine we would feel the same way if a farmer, who had leased land from a landowner for years, paying via a portion of his crops, suddenly offered to buy it with a loan from the bank, and thereafter, following a systematic improvement of the soil, doubled his profits.  Even if he found oil one day we'd cheer him on and produce a half-hour comedy about his new life in Beverley Hills Greenwich.

In the United States we generally do not tax contingent, unrealized gains.  Why do shareholder's think they are entitled to them?

But, cry the masses, shareholders have no say in the company.  They cannot easily change management or challenge/force the deal effectively because (proxy contests are expensive/boards are staggered/there are poison pill arrangements in place).  Such masses often forget the purpose of the separation of ownership and control, of capital and competence- to permit management specialization generally unmolested by the old widow who wants to paint the plant pink.

It is also easily forgotten that shareholders knew or should have known full well how much power they had or didn't have when they bought the shares.  It is not as if such matters are opaque.  Arguing for more control (absent paying a premium for it) after purchasing shares you knew lacked such control strikes me as awfully disingenuous.  Not that that surprises anyone.

"Aren't managers who mount MBOs guilty of a conflict of interest?" wonders one commentator.  Here, I cannot help but be amused.  Despite what you might hear on CNN, one is not "guilty of a conflict of interest."  A conflict of interest is not, of itself, a crime.  Think on this long and hard.  It is easy to get another impression in this day and age.  A conflict of interest simply exists, or does not exist.  The solution to one that exists is simple.  Disclosure, additional scrutiny.  I don't think anyone observing an MBO will fail to recognize the various roles of the parties involved.  The danger of hidden self-dealing is actually quite low in a public transaction.  And, frankly given the transparency of the process, if outright fraud, (say, non disclosure of good news or dumbing down of the numbers pending the MBO) occurs you can well bet that the plaintiff's bar will be on it like white on rice, that is unless you want to take the somewhat dense position that there aren't enough shareholder lawsuits in the United States.

Really worried about some manager making too much in an MBO that you don't have the power to prevent?  Don't buy the stock in the first place.  Stick to firms with corporate governance policies that make MBOs nearly impossible, or slates of directors unlikely to approve such measures.  One public company director I know responds to MBO proposals by asking the manager to quit first, and then mount the bid if she wants the board's support.  Are all directors so tough?  Probably not.  If that's important to you as a shareholder, find out and vote with your wallet.

Let's take Sorkin's suggestions one by one:

Let minority shareholders decide, too.  While it’s understood that a controlling shareholder has the right to steer the company, that investor shouldn’t be able to do so at the expense of minority shareholders. You should be irate to hear Isadore Sharp, the chief executive and controlling shareholder of Four Seasons Hotels, tell shareholders that his offer for the company “is the only one I am prepared to pursue.” The Dolans of Cablevision pulled the same stunt.

That’s fine, but transactions like this should then require a majority of the minority shareholders to approve the deal. It’s not enough to have an independent committee of board members and an investment bank’s fairness opinion bless a deal that is clearly below market value simply because the controlling shareholder won’t allow a true market for the company.

Why should you, or anyone else be irate?  It was the daft shareholder that did not make herself aware of the corporate governance nuances of the company she just bought a piece of.  I have no sympathy for shareholders who willingly buy into Class B shares when there is a Class A with supermajority voting rights and then complain that they are being "oppressed" and file a minority shareholder oppression lawsuit as if we were dealing with a closely held firm.  These shareholders neither paid for control nor should they have it after having acquired the shares at a discount to what control bearing shares would have called for.  Again, they knew full well the nature of the transaction they were entering into.  Changing the rules now, particularly with regulation, is folly.

The reality is that if corporate governance is actually worth something to shareholders they will bid up or down based on their ability to oust management or block a transaction.  This is what gives rise to things like the "Dolan Factor," at Cablevision.  Even the New York Post is in touch with this effect.  When you recognize this you see that these shareholders want a free lunch.  Non-control prices for controlling shares.  Poor shareholders.  Even assuming our shareholders were a sympathetic bunch, why should this sort of thing be regulated, rather than left to each firm to decide via its public by-laws so that the market can price control accordingly?

Sorkin continues:

Use truly independent advisors. The investment bankers that run these auctions have a huge hand in shaping their outcome. Since management is part of the buying group, it already feels like an inside job. When an adviser has a longtime relationship with the family or company, it feels even more that way.

Again, one is not "guilty" of a conflict of interest.  And absent some actual showing of wrongdoing, which would, once again, garner the wrath of the plaintiff's bar, I am not particularly sympathetic.  This is, however, the more compelling of Sorkin's issues (for whatever that's worth).

More from Sorkin:

Give public shareholders a stake.  One reason shareholders are so suspicious of take-private deals is that they see private equity firms quickly flipping companies they just bought onto the public market and making a multiple of their original investment. Here’s a solution: Offer shareholders as much as a 10 percent stake in the deal. That way, shareholders who see long-term value — and are willing to have illiquid shares — can go along for the ride and won’t feel ripped off if the deal turns out to be a grand slam.

How to structure this would be a little tricky, however. It should be available only to shareholders who held the company before it announced its sale, so that you don’t have arbitrageurs and other fast money jumping into the fray.

A little tricky?  I'll say.  Now we are classifying shareholders based on their corporate structure and proposing regulations that say who can purchase public shares when.  Enforcement of this clause would require the SEC to develop a set of "shareholder thought police" to divine the intent of shareholders before permitting them to buy.  We can't let those evil fast-money shareholders get involved.  Instead, we have to give, not sell mind you, but give, shares away to existing shareholders because... well because they are existing shareholders.  Are they going to share in the risk going forward?  Not really.  The premium they were paid on their existing shares means that they were effectively paid to take 10% of their prior holdings.  That's about as backwards a plan as I have seen.  It is also pretty obvious that Sorkin doesn't understand the important role arbitrageurs play in markets.  That's not really surprising though, is it?

What is surprising, a little surprising anyhow, is the hypocrisy of Sorkin here.  Of course, this part of his plan screws shareholders by artificially depressing the price.  Hopefully, these shareholders will be able to sue Sorkin for the difference.  Wasn't it the same Sorkin that was moaning over supermajority holders who prevent a "real market for shares" just a few paragraphs back?  Looks to me like Sorkin has just become what he despises- one of those fascists who doesn't permit a "real market" for public shares.

What about regulation?  Does Sorkin propose that these shareholders who keep a stake will also be entitled to public disclosure of financials?  Will the company still have to file with the SEC?  Comply with SarOx?  How exactly will shareholders be convinced to forgo their rights to SEC regulation and disclosure in the shares?  If so, will the shareholders have to be "qualified persons" as if it were a private placement?  If not, what assurance does the SEC have that they are sophisticated enough to hold what amounts to private placement shares?  The SEC would never permit such an offering in other contexts, why are shareholders now suddenly smart enough to take advantage of a QP-type deal without being QPs?  What company would ever embark on a buyout in that circumstance in any event?  Few, if any.  It has the effect of locking effectively all companies into the public equity markets and the burdensome disclosure regimes for eternity or breaking safe-harbor laws.  Sorry, I just don't see it. 

Next genius idea:

Show us the business plan.  ...shareholders should have a chance to see the company’s future business plan so they can judge for themselves whether the same strategy could be accomplished if the company remained public. Companies shouldn’t have to give away all their secrets, but they should make available the same business plan that they provide to the banks and debt holders that are financing the transaction.

Shareholders should either take their premium and go on to other things or protest the deal.  Car dealers do not ask for a statement of use for a car before selling it to someone in order to determine the price.  Why are shareholders different exactly?

The reality is that the public equity markets are just not the place for many companies.  The public markets and public shareholders have failed, perhaps because they have become intensely short-term in the last 40 years, any number of companies that could prosper if they were free to manage their balance sheet aggressively (but not too aggressively), adopt long-term strategies that might well result in break-even returns for several years before bearing fruit.  The kinds of strategies that the public markets simply have no patience for.  Why should we look askance at the move to more efficient allocation of capital?  Because it is not "fair?"  And who's "fair" is it?

Sorkin's approach has the common thread I see quite a bit with the neo-marxists who struggle to redistribute "windfalls" to other segments of society who cannot be bothered to think long term or otherwise create wealth.  It is the thermodynamic theory of collectivism:

First, make sure they cannot win.  (e.g., a windfall profits tax).
Second, make sure they cannot break even. (minority shareholder oppression suits, compulsory disclosure of post-transaction plans).
Third, make sure they cannot get out of the game (compulsory public equity markets participation).

This is the sure sign of a scheme that is failing, its death rattle gurgling.  I am reminded of the music industry, desperately trying to legislate themselves into insulation, any sort of insulation, from any sort of progress that forces them to rethink their ancient and now flawed business model.

Those seeking to improve "fairness" (ahem, Dr. Mark Klein) would do well instead to concentrate on understanding the concept of risk adjusted returns and get out of the way.  I'm not holding my breath.

Monday, December 04, 2006

No Parole Either

capital checks in... but it doesn't check out... The Unknown Professor over at Financial Rounds points us today to a piece on Market Watch on dual-class shareholder structures in the public equity markets.  Penned by Russ Britt, the "Los Angeles bureau chief for MarketWatch," the piece casts dual-class structures as some sort of control-tax dodge, pitting victimized shareholders against the highly unattractive demon of nepotistic media dynasties in what amounts to a thinly veiled call to arms against the practice.

"Management wants the best of both worlds," said Nell Minow, founder of the watchdog group Corporate Library. "They want the access to capital of the public markets and they want the control of the private markets, and dual-class allows them to get that."

Let's ignore for a moment that it is in fact the shareholders themselves, who willingly buy into the dual class system in the first place, and not some sort of lawyerly slight of hand which "allows [management] to get that."

The reality is that dual-class structures can serve important roles.  Their traditional purpose in the media context, the Market Watch piece grudgingly admits, has been to insulate media control from the short-term whims of the market.  Clearly, any anti-takeover provision which entrenches management will have this effect to some degree.  Stock price, however, is still a strong motivator and to the extent control is important to investors castrated shares will trade at a discount to uncut issues.  This point, apparently, needs to be highlighted for almost everyone who makes "fairness" arguments about these sorts of practices:

Investors have already managed to pick up the assets at a discount because the lack of control has already been priced in, or;
Control in the company issuing the shares is so unimportant that it hasn't impacted the shares.  One might wonder in this eventuality why there would be any need of adjustment.

In fact, to now, through legislation, regulation or fiat, force a change in that structure would unjustly enrich shareholders who knowingly paid non-control prices and have been granted a subsidy by regulators and at the expense of the company and management once control is handed to them.

Consider the S-1 of one of my least favorite companies:

Corporate Structure: We are creating a corporate structure that is designed for stability over long time horizons. By investing in Google, you are placing an unusual long-term bet on the team, especially Sergey and me, and on our innovative approach. We want Google to become an important and significant institution. That takes time, stability and independence.

We bridge the media and technology industries, both of which have experienced considerable consolidation and attempted hostile takeovers. In the transition to public ownership, we have set up a corporate structure that will make it harder for outside parties to take over or influence Google. This structure will also make it easier for our management team to follow the long term, innovative approach emphasized earlier. This structure, called a dual class voting structure, is described elsewhere in this prospectus.

The main effect of this structure is likely to leave our team, especially Sergey and me, with significant control over the company’s decisions and fate, as Google shares change hands. New investors will fully share in Google’s long term growth but will have less influence over its strategic decisions than they would at most public companies.

While this structure is unusual for technology companies, it is common in the media business and has had a profound importance there. The New York Times Company, the Washington Post Company and Dow Jones, the publisher of The Wall Street Journal, all have similar dual class ownership structures. Media observers frequently point out that dual class ownership has allowed these companies to concentrate on their core, long-term interest in serious news coverage, despite fluctuations in quarterly results.

The Berkshire Hathaway company has applied the same structure, with similar beneficial effects. From the point of view of long-term success in advancing a company’s core values, the structure has clearly been an advantage. Academic studies have shown that from a purely economic point of view, dual class structures have not harmed the share price of companies.

The shares of each of our classes have identical economic rights and differ only as to voting rights. Google has prospered as a private company. As a public company, we believe a dual class voting structure will enable us to retain many of the positive aspects of being private.

We understand some investors do not favor dual class structures. We have considered this point of view carefully, and we have not made our decision lightly. We are convinced that everyone associated with Google—including new investors—will benefit from this structure.

This brings me back to the original "have it both ways" quote:

"They want the access to capital of the public markets and they want the control of the private markets, and dual-class allows them to get that."

Yes, exactly.  Have we come to the point where a long-term corporate strategy is so antithetical to capital markets that we must abolish anything that encourages it?  It strikes me reading this again that Nell Minow is trying to strip one of the last real defenses against short-term public market forces in public equities and what I have started calling "the tyranny of the quarterlies,"  away.  Once again, markets are beginning to look like the laws of thermodynamics.  Don't let companies win.  Don't let them break even.  Don't let them get out of the game.

Adding in the changes Herb Greenberg advocates and we'll end up with a second rate capital market s system in no time.  What will we do then?  Why, drive out all the liquidity and collar private equity to prevent public shareholders from being "cheated" by unlocking value that the public markets have all but destroyed.

Moving to London looks much more appealing today.

Thursday, March 01, 2007

Just Try to Get Away

no escape Repeat offendersLoyal readers will be aware that I often see signs that regulators would like to simulate the laws of thermodynamics in capital markets (or shall we just say in business endeavors of any kind).  You know the laws:  1. "In any process the total energy pf the universe stays constant."  2. "There is no process that, operating in a circle, produces no other effect than the subtraction of a positive amount of heat from a reservoir and the production of an equal amount of work."  3. "As temperature approaches absolute zero, the entropy of a system approaches a constant."  Or, in my version (read: the version I stole from Allen Ginsberg): "You can't win, you can't break even, and you can't get out of the game."

The similarities have become so common, and I estimate they will now become even more frequent given the emerging political bias in the United States and the United Kingdom, that I have started a new category "Thermodynamics," here on Going Private, to discuss the propensity of regulators to penalize profitable businesses by shoving them towards the tugging gravity wells and, by extension, closer and closer to the event horizons of the many supermassive bureaucratic institutions that make up the governmental universe.

Little surprise, therefore, to find the increasingly massive orbital body of the United Kingdom's City minister, appropriately named Ed Balls (I couldn't make this stuff up if I doubled the rate on my morphine drip), working to drag private equity into the ravages of the third law of capitaldynamics, at least if the quote proffered by the Financial Times (subscription required) is to be believed.

My message to private equity is that coming forward with proposals for greater transparency in the way they operate would be in the interests of their industry and the UK economy more generally.

I suppose this could more clearly be translated to: "Yes, we know we've made disclosure oppressively burdensome and imposed legal and criminal liability that rivals the sorts of incarceration that one might earn for high treason.  And yes, we understand that you've fled the public markets in droves as a consequence, since these operational requirements have made it high inefficient to continue to exist as a public firm, but we have decided to cut off that escape route now too since you seem to be getting quite a bit too much work done quite a bit too well.  Oh, and just wait until you try to move your business out of the jurisdiction to escape.  Quite sorry, really, old chap.  Oh, and there is a fellow from inland revenue here to see you.  Shall I show him in?"

Tuesday, September 11, 2007

Green in the Red

power for some It is difficult not to gloat at the fate of green investing or crack a silent grin at the unintended consequences the "green economy," has begun to inflict- that is until one realizes the harm such nonsense is doing to the rest of us.  In my case, this is partly because I resent the thick air of smugness, the snide sneer belaying the unspoken boast of moral superiority among those who, for example, drive about the sprawling highways of California in hybrid cars, pledge to burn only ethanol, and buy "carbon offsets" to undo the damage to the earth inflicted by the 22,000 kilowatt hours sucked down by their 10,000 square foot homes every month.  In short, I take pleasure in the misfortunes of green snobs.

The primary reason is because the green snobs are engaged in a dirty business.  Wittingly or unwittingly they use very old and very dangerous rhetoric to sabotage free markets.  This is not a new approach, it is so old, in fact, that it has become a very reliable gauge to attribute rank and naked populism for the sake of accumulating power to any public figure who purports to have an altruistic solution to some social problem.  Consider this passage:

One of the great mistakes is to judge policies and programs by their intentions rather than their results. We all know a famous road that is paved with good intentions. The people who go around talking about their soft heart -- I share their -- I admire them for the softness of their heart, but unfortunately, it very often extends to their head as well, because the fact is that the programs that are labeled as being for the poor, for the needy, almost always have effects exactly the opposite of those which their well-intentioned sponsors intend them to have.

This, of course, was Milton Friedman back in 1975.  I think Professor Friedman was a little generous, but this may be a sign of the times for, you see, today even the most docile investigation into our self-righteous, green do-gooder will reveal that they are using their hybrid car (which actually has a larger lifetime energy impact per mile than does your politically incorrect gas guzzler) to speed their illegal narcotics developed by the very pharmaceutical companies they have been demonizing in the press for years across the California highway system at 100 miles per hour, so they can arrive in time to celebrate the riches they reaped by investing their "carbon offset" payments in the private equity vehicle they co-founded.

It doesn't bother me one bit that the self-appointed leader of such movements shells out $30,000 in electricity and natural gas bills a year even after the contribution of solar panels and the like.  This is as it should be.  Electricity is provided at a price and paid for.  What bothers me is two-fold:

First, that a semi-market system is good enough for the green snobs to use in vast quantities for their purposes, but not for the rest of the planet.  Any hint that their overt consumption is out of the ordinary is excused away with some argument akin to: "How is it fair to compare an active politician's power use to the average family?"  The implication is that the business of the green leaders is more important than that of the rest of the planet.  They are excepted from compliance.  But, as an affirmative defense, they also "offset" their egregious use of resources with "carbon offsets."  Never mind that these are thinly veiled private equity investments inaccessible to any but the rich by virtue of SEC net-worth edicts.  Really, I am less offended by the investment structure than I am in the absolutely non-existent attempt to even mask the naked fraud being perpetrated here.  There isn't even the slightest effort to make a legitimate argument that investing in a private equity vehicle is even remotely connected to "carbon offsets."  It is as if they never thought anyone would dare to look.

Second, that these same populists have created an inefficient power market in the first place by effectively fixing prices for consumers.  This has, of course, ostensibly been to insulate the poor and needy from expensive power or (god forbid) fluctuations in its price, and to prevent the greedy power companies from taking advantage of consumers.  Why, in this day and age, a spot price for kilowatt hours is not displayed in every home on a digital readout, permitting users to allocate their power usage according to cost, and that power to be priced according to demand, is beyond me.  But then, I look to the green snobs and realize, suddenly, who they are.  They are the politburo members, sped quickly down the reserved center lane, past the teeming crowds who must wait in traffic.  Spared the ravages of the system they created for "the rest," so that they can conduct the important business of the state in comfort and style- unmolested by scrutiny.  Insulated by their smug superiority and their certainty that their bold plans will prevail over such trivial things as supply and demand.  So certain of their entitlement that they need not even pretend to justify their immunity to the rules for "the rest."

In this context, the Going Private reader will understand my skepticism then at the many incentive programs for ethanol that have cropped up (if you will excuse the pun) in the last several years.  That same skepticism is the source of the sad, thin smile on my face today after reading the Financial Times.  To wit:

Governments need to scrap subsidies for biofuels, as the current rush to support alternative energy sources will lead to surging food prices and the potential destruction of natural habitats, the Organisation for Economic Co-operation and Development will warn on Tuesday.

The OECD will say in a report to be discussed by ministers on Tuesday that politicians are rigging the market in favour of an untried technology that will have only limited impact on climate change.

“The current push to expand the use of biofuels is creating unsustainable tensions that will disrupt markets without generating significant environmental benefits,” say the authors of the study, a copy of which has been obtained by the Financial Times.

The survey says biofuels would cut energy-related emissions by 3 per cent at most. This benefit would come at a huge cost, which would swiftly make them unpopular among taxpayers.

The study estimates the US alone spends $7bn (€5bn) a year helping make ethanol, with each tonne of carbon dioxide avoided costing more than $500. In the EU, it can be almost 10 times that.

It says biofuels could lead to some damage to the environment. “As long as environmental values are not adequately priced in the market, there will be powerful incentives to replace natural eco-systems such as forests, wetlands and pasture with dedicated bio-energy crops,” it says.

Monday, February 11, 2008

There is No Such Thing as a Risk-Free Lunch

damn the models, full speed ahead The always observant readership of Going Private will have little difficulty sharing my frustration with prominent public figures who, in their often dangerous zeal to fulfill the promise of Lake Wobegon for all their constituents, somehow believe that they can fundamentally alter or suspend the laws of mathematics, obtain return with no risk and otherwise lower the expense of daily endeavors by merely legislating that it should be so.  Of course, these efforts center around a particular type of moral hazard, namely, short-term political gain funded via the issuance of a big bond with a brutally compounding PIK tier and denominated in units of "later economic disaster."  The hitch is that the debtors end up being someone other than the issuer.  Examples, of course, abound, wherever public officials seek to deliver the long-term-impossible in the short-term.  The most charitable interpretation of these goings on is that public officials are daft.  I suspect the more likely reality is that some subset are quite cunning.

The 1996 California power markets, wherein a combination of fixed retail prices (below cost in some instances) to consumers, floating wholesale prices with resort to the spot market to resolve supply shortages, and strong disincentives to create more generation capacity, permitted our resident economic disaster bond issuers to promise (and for a time deliver) absurdly low electricity costs to the left coast population (who had grown quite endeared with low prices, to the point of badly abusing anyone who failed to keep them that way) for years.  These prices were, of course, often funded by utility bonds during the "transition period" to "free markets" (or the left coast equivalent anyhow) meaning the costs weren't really "low," they were just concealed in taxpayer funded municipal bonds and the like.

I suspect, dear reader, that you might already be aware of how annoyed I am with the word "fair."  This might be a good opportunity to introduce another one of my least favorites: "affordable."  This one particularly annoys me when "affordable" actually means "distribute costs to the productive class via cost-laundering them into the tax base."  It gets even more irritating when it means that compounded interest is added to the bill.

And once such a system is in place, surprise, horror, oh woe indeed, when, bound to service customers, power providers are forced into the spot market for electricity to make up shortfalls (helped along by the awfully convenient maintenance outages among some plants, but that's another issue).

Of course, because of the price capping, market actors happily bought up price-capped electricity in California from an impossibly naive market system (designed in the French tradition) to export to real markets where prices actually reflected reality.  This had the effect of decreasing even further the already problematic supply in California.  Wholesale prices quickly outstripped retail prices, an amusing turn of events, that is, if you aren't one of the debtors listed on the economic disaster bond that, day by day, grows ever closer to maturing.

Astute Going Private readers might be expected to have the same reaction of annoyance to this logic chain:

1.  Health care prices are so high they border on un-affordable.
2.  Everyone has a right to world-class (not merely sufficient) health care.
3.  Since boundless health care is so expensive, and everyone has a right to the best, we are going to make it free for everyone.

More sophisticated versions of this basic yarn might alter the pitch somewhat by changing the "right" asserted to an inalienable right to (cheap) insurance.  This is an improvement in so far as it introduces some risk pricing mechanism.  Unfortunately, it is hard to imagine that premiums will actually be risk based in a system where the goal is "universal coverage."  How can they be?  I have mused on what an old Lloyd's of London broker might have thought of the idea of insurance as a "right."  (Predictably, Ben Stein was involved).  Needless to say, I see a big bond issue on the horizon, dear readers.

Readers might recognize my continued attentions to these kinds of things in the Going Private category "Thermodynamics."  Sufficiently carnivorous readers will already be wondering what information asymmetries and market flaws may be lurking underneath such poli-economic moral hazards, and how to take advantage of them.  Fear not, there are many.  By virtue of an odd confluence of events, one in particular has caught my attention.

One of the chief properties of these pseudo-market delusions is the conviction that the inevitable is preventable, and that, if not, it should be cheap to insure against.  No one should stand in the way of every citizen's god given right to build on a 100 year flood plane (5.2 MB .pdf) (with cheap insurance, of course).  In this connection, catastrophe risk has become a pet project of mine.  Particularly where public officials get involved.

No story of improper risk pricing would be complete without a government funded buffer fund to soak up undesirable pricing signals that might actually reflect risk.  In the case of Florida, the Florida Hurricane Catastrophe Fund is the central character cut from this cloth.  In fact, it fits the bill perfectly.  The FHCF is a political animal, subject to the whims of legislators and their annoyingly short-term, populist aspirations.  This is a problem insofar as it provides artificially cheap re-insurance to the Florida market to keep insurers either from fleeing a circumstance where risk pricing is impossible, or quoting prices substantial enough to (gasp) prevent people from building in a spot where hurricanes are a (relatively) common occurrence.  This all, of course, assumes that insurers will pass the savings on, and it is not at all clear they would.

Barely a year goes by at the FHCF without some arbitrary tinkering, and major revamps in the nature and costs of coverage are not infrequent.  The impact is severe.  One market participant pointed out to me that premiums bounce wildly in response to, for instance, a 3000 basis point change in reinsurance costs as legislative whims either permit or forbid a given insurer from taking advantage of the program's rates.  Says this commentator: "I'm not surprised Florida homeowners feel like they are being jerked around with their premiums- they are."

One might be tempted to assign a high degree of confidence to such a fund, particularly given the level of public trust tied up in the confidence investors, insurers and homeowners have in the entity.  Such a temptation would most certainly require an upstream battle against the formidable currents of historical experience.  "Smart money," is not fooled.  Many market participants discount recoveries from the FHCF by more than 12%.  This snapshot balance sheet might shed some light on the deeper issues.  Those who suspect this kind of a discount reflects the fear that there is something more than a vanishingly small risk that the FHCF won't be able to meet the such obligations to insurers as it has assumed, might be on to something.  Never fear, dear readers, for Florida municipal bonds will be used to bolster the FHCF's obligations in the event of any concerns.  What kind of confidence will Florida municipal bonds enjoy in such an eventuality?  Wow, look at the time, how did it get so late?  Well, we have a lot to cover today so let's move on to another topic, shall we?

Let's talk about FHCF's premiums, yes?  That seems a safe topic.  I suppose we should avoid in our discussions those premiums rates that fail to cover even the historical losses.  I suppose we might also be better off leaving aside for a moment the fact that the FHCF tends to compute risks for the purposes of pegging premiums against the last calendar year of hurricane losses.  Bit of a limited sample size, no?  Luckily, 2006 and 2007 were boring years so reinsurers will enjoy minimal premiums for the next year to come.  Says one commentator I corresponded with: "The FHCF isn't even matching their losses one for one, much less factoring in a risk premium, operating costs, or the like. If a reinsurer charged such rates, their investors would have them murdered."

In essence, Florida is short Hurricanes, short the industry risk models, short the historical loss records, and long their credit worthiness.

These risk models bear some scrutiny as a general matter, perhaps.  Many reinsurers use their own models, or at least claim to, but three industry models tend to predominate, or at least represent the "baseline" risk model the industry seems to hinge on.  RiskLink, Clasic/2 and WorldCat.

The basic division in modeling philosophies seems to fall into one of two buckets.

1.  Frequency and intensity of hurricanes are increasing, making reliance on a long-term historical record problematic.  (Cause is sort of beyond this discussion, but it bears mentioning that global warming is not the only potential culprit.  An Atlantic Multidecadal Oscillation (AMO) warm cycle could create the same effect.

2.  Stick with the historical record.

These two differences make for very dramatic differences in loss predictions, as you might imagine.  You might also imagine that a model that results in lower loss predictions than either is either the product of some giant step forward in model accuracy by a quasi-governmental entity, or folly.  I suspect Going Private readers will have their own guesses on this question.

Oh, I forgot one:

3.  Adopt an average yearly loss model and use sample size n=1 after the two mildest Atlantic hurricane seasons in recent memory.

It is also worth noting that recently, "real" catastrophe models have "missed low" on loss prediction (Wilma, Katrina) with predictable consequences.  So what does it mean when the FHCF isn't even matching loses before the risk premium?

Never fear, dear readers, Citizens Property Insurance Corporation has for many years been the "state run insurer of 'last resort.'"  Well, until 2006.  True, Citizens enjoys significant tax breaks and doesn't bear the burdens of normal, private insurers, but, as of 2007 they have been tapped to be a "competitive player" in the "overpriced markets."  How surprising will it be for the astute Going Private reader to discover that the "wind premium" Citizens charges often doesn't even cover the historical average loss from hurricanes, tornado and hail?  Closer to the coast, Citizen's premiums start to look absurdly low.  One might imagine the impact on any insurer in the Florida market with a reasonable risk model.  (Or at least one that's not insane).  Clearly, they cannot compete with absurdly low premiums driven by major state subsidies and a rather... well... unique approach to risk modeling.

Now consider that Citizens is effectively obligated to offer policies to potential insured that the major private insurers in the market will drop as too risky, and it becomes fairly easy to see that Citizens portfolio is probably highly acidic.  Says one commentator: "Even a severely conservative 100 year storm model would tag Citizens with $10 billion in losses."

The most naive of Going Private readers will be able to construct the basic principles of insurance premium generation.  Premiums should cover all expected losses from all insured risks.  Premiums must at least match payouts over the long term.  Add in operating expenses, risk of ruin margin and you have the beginnings of a premium model.

Coming full circle, it seems clear that Florida either is not possessed of sufficient sophistication to grasp these concepts, or, perhaps more insidiously, someone is (someones are) making a huge bet, realizing short-term political gains by keeping premiums artificially low and hoping to be off and away before the poli-economic disaster bond matures.  This is never more apparent than when watching officials deal with insurers.  Rate increases are denied routinely, rate decreases are often forced, even as they dip below the levels any sane actuary would tolerate.  "Look at all those profits your company is making in Illinois, we aren't going to let you steal from our homeowners here in Florida, I tell you boy-o."

The result is that many insurers in Florida are structuring losses in the property markets and trying to make up the difference with e.g., auto premiums.  It is amusing that the state which "composes over half of the hurricane risk in the United States, somehow believes that its share of premium (which is already far below that), is way too high and unfair."

As one might expect, the major insurers (coincidentally the ones best able to provide stability and reduce volatility) are pulling out of the market.  "Mitigating Florida exposure," has become a required corporate strategy.  As I explored this issue a little bird whispered to me that at least one of the big three is considering removing any Florida exposure whatsoever from their portfolio.  (Similar things have happened in OB/GYN malpractice insurance in some states).

So what if (when) a catastrophe loss is around the corner?  Well, don't worry dear citizens, Florida has a plan composed of several layered defenses to such an unlikely eventuality:

1.  Issue bonds.  (Read: Charge the taxpayers).
2.  Raise taxes and real estate assessments.  (Read: Charge the taxpayers).
3.  Insurance company assessments with consummate cost passthroughs.  (Read: Charge the insurance companies and taxpayers).

Long ago I was privileged enough to take a fascinating graduate class on low intensity conflict and asymmetric warfare.  I still giggle at the optics of that.  Me, at least five years the junior of the next youngest student, sitting in a class filled with Naval Intelligence officers, a pair of FBI agents, these three guys from "SAIC," who never spoke a word beyond "We're from SAIC," some State Department folk and an attorney who specialized in National Security Law.

My favorite part of the class (and a major portion of it) was the discussion of the destabilization of systems and institutions, which eventually took the form of fifteen key goals an irregular actor could employ to cause the most problems for larger and more resourced adversaries. 

Three of these relevant to my discussion here include:

A.  Disrupt basic communications in order to force reliance on more vulnerable channels.
B.  Employ "area denial" strategies to prevent effective operations and require substantial resources for defense.
C.  Make it expensive (literally and politically) for allies (foreign and domestic) to continue their support.

One might think that Florida had waged such a campaign against insurers.

1.  They are unable to use risk pricing models or enjoy the efficiencies of the market because of the stranglehold on rate changes.
2.  They are increasingly priced out of the market both by the rate restrictions and the presence of a subsidized non-market constrained actor having the effect of denying the market to any insurer who wants to actually be profitable.
3.  Relations with major insurers have been so damaged as to make their cooperation in times of difficulty nearly impossible.  (Calling senior insurance executives "vipers," for instance).

I suppose one might call the circumstances in this connection, "interesting."

Wednesday, February 27, 2008

The War on Error

war on error warriors Defeating errorism requires a long-term strategy and a break with old patterns. We are fighting a new enemy with global reach. The United States can no longer simply rely on deterrence to keep the errorists at bay or defensive measures to thwart them at the last moment. The fight must be taken to the enemy, to keep them on the run. To succeed in our own efforts, we need the support and concerted action of friends and allies. We must join with others to deny the errorists what they need to survive: safe haven, financial support, and the support and protection that certain nation-states historically have given them.

The advance of freedom and human dignity through democracy is the long-term solution to the transnational errorism of today.  To create the space and time for that long-term solution to take root, there are four steps we will take in the short term.

Prevent attacks by errorist networks (private equity partnerships, hedge funds, speculators) before they occur.  A government has no higher obligation than to protect the lives and livelihoods of its citizens.  The hard core of the errorists cannot be deterred or reformed; they must be tracked down, killed, or captured.  They must be cut off from the network of individuals and institutions on which they depend for support.  That network must in turn be deterred, disrupted, and disabled by using a broad range of tools.

Deny Weapons of Mass Derivatives (WMD) to rogue traders and to errorist allies who would use them without hesitation.  Errorists have a perverse moral code that glorifies deliberately targeting innocent civilians.  Errorists try to inflict as many financial casualties as possible and seek WMD to this end.  Denying errorists WMD will require new tools and new international approaches.  We are working with partner nations to improve security in vulnerable markets worldwide and bolster the ability of states to detect, disrupt, and respond to errorist activity involving WMD.

Deny errorist groups (hedge funds) the support and sanctuary of rogue (tax haven) states.  The United States and its allies in the War on Error make no distinction between those who commit acts of error and those who support and harbor them, because they are equally guilty of financial murder.  Any government that chooses to be an ally of error, such as The Cayman Islands or the Netherlands, has chosen to be an enemy of freedom, justice, and peace.  The world must hold those regimes to account.

Deny the errorists control of any nation that they would use as a base and launching pad for error.  The errorists’ goal is to overthrow a growing bubble; claim a strategic country as a haven for error; destabilize artificial markets; and strike America and other free nations with ever-increasing bubble violence.  This we can never allow.  This is why success in The United Kingdom and The Cayman Islands is vital, and why we must prevent errorists from exploiting ungoverned areas.

America will lead in this fight, and we will continue to partner with allies and will recruit new friends to join the battle.

There is a basic bit of hypocrisy for which the edges, the contours, the topography, so to speak, has been, to me at least, quite evasive.  For whatever reason though, recently, it has come into sharper focus.

These pages have made much of the modern propensity to tax success, reward stupidity and criminalize failure.  (And by "failure," I mean educated risk-taking that ends badly.  I mean a bit of sage tangling with fates who elect not to smile upon your otherwise clever, bold and daring venture).  I have speculated on the causes of these dynamics in the entries that make up Thermodynamics, and a long standing series on Punishing Talent for Fun and Profit.  I have wondered often after the details.  I am left convinced that the War on Error is a social phenomenon rooted at the core in envy and malice.  It is disguised as a question of "fairness."  Of course, given that the average global per capita income is substantially below $10,000 per year, no one is suggesting we get that fair in the Western world.

But the War on Error is not merciless.  Not all error is verboten.  But for error to be permissible, you must have been totally unable to cover your losses.  You must have been entirely out of your league.  Risk management must have been beyond you, or too expensive for you.  You had to really be swinging for the fences with everything you had.  In short, you had to make a huge bet on interest rates not moving a quarter point in 30 years, or you'd lose everything and still owe two banks large numbers that dwarf your yearly income.  In these cases, when the victims are sympathetic enough, when they have been totally, utterly daft and irresponsible, our heart (or at least our tax dollars) pour out to them and, for them at least, salvation is close at hand.

There is a corollary, of course.  You can win by being smart, working hard and getting it right.  You can even do it at the expense of the stupid who had no business playing the game in the first place.  Of course, we will tax the stuffing out of your success, but you are expected to keep quiet about that.  But not too dramatically, lest Michael Lewis, who I am consistently tempted to appreciate until I read one too many of his sentences, pulls your name (or John Paulson's name in this case) from a list of financial successes and pecks out something resembling the venom-laden "How to Survive the Fortune You Made in Subprime."

For not since Michael Milken bootstrapped hostile raiders of public companies has Wall Street been so directly implicated in the misery of the little guy.

Just to remind you, this would be the little guy who took a huge flier at interest rates so he could brag about his square footage and oversized yard- and lost.  Lost with no reserve fund of any kind.  And the Michael Milken in this case would be a sharp market player who saw it coming before almost anyone else, and was willing to bet on it.  Big.  And if you win in this fashion, where the victim was so stupid that it just insults the discipline of behavioral economics?  What then?

[Paulson], and [other subprime shorts], may face a real social risk: Having made their fortune they must now subject it to public inspection. Articles will be written, hearings held, and lawsuits filed -- and all of these will be drawn inexorably toward the people who profited from the misery of others.

Funny, the rules must have changed since Joseph Kennedy's day.

(With apologies to the National Security Council's, 2006 National Security Strategy of the United States.  Describing the import of the fact that I can remove 20 "t"'s, change a pair of country names and one acronym to describe with near perfection the misguided, contemporary assault on modern finance and capital markets, is left as an exercise for the student).

Monday, June 16, 2008

From Shareholders to Stakeholders

Unio I am an occasional reader of Megan McArdle over at Asymmetrical Information.  Take from this what you will, remembering that I also read the Huffington Post occasionally.  Ms. McArdle manages to attract quite a bit of ire.  I haven't quite developed the "universal theory of McArdle ire" yet, but I suspect the variables "political leaning," "logic quotient" and "vocal volume," are among the key variables in any formulation.  No surprise, then, that some of her readers might be annoyed should she have the temerity to suggest that unions might not contribute much to labor efficiency.  Ms. McArdle replies:

"But the idea that companies maximize short term profits at the expense of long-term returns is, to put it mildly, unproven."

Ah, but she fell for the reader's ruse.  Pity.

Throwing up the straw man of "the tyranny of the quarterlies" has nothing at all to do with the more central question the issue presents. The singular quandry when considering unions (or employees in general) is quite simple:  What is the function of the corporation?  The question of what public markets, and their rather obvious devotion to short term results, bring to the table is entirely divorced from the question of unions.  Moreover, the answer to short-termism is far simpler than resort to a survey of the academic literature on the presence (or absence) of short-term incentive effects of public markets.  This is because:

1.  To the extent there is a disutility to short-term focus of public markets, market actors have a fairly low-transaction cost recourse to recover any lost utility.  Namely, the "going private" transaction.  It should be obvious to anyone that where predicted loss due to costs of the public markets (like short-term focus and the deterrent for long term investment) exceeds going-private transaction costs, it is efficient to conduct a go-private buyout.  The imbalance is usually self correcting, provided the union doesn't resist the going-private transaction (ahem).  I might add that any study worth the paper its written on reports significant efficiency gains for properly executed going-private transactions (i.e. those where leverage doesn't get out of hand).  I suppose the argument here is that losses to the corporation are the increased cost of captial when stock price is depressed.  I'm not sure why unions would be upset by stock price except in captial intensive firms that are regular Wall Street customers owning to their constant (and frequent) resort to the capital markets to fuel growth.  In these cases, stock price could well cost employee jobs- but these are very forseeable effects.

2.  While variations in short term results may cause short term fluctuations in stock price, only management that has been poorly incentivized to focus on long term growth (through appropriate restricted share, option and other performance based compensation) will much care about "today's stock price" as opposed to, say, the 180 day moving average of same, or year on year change in stock price.  Then again, some stocks that don't look like they should be may well be very short term plays in capital markets.  Those equity investors looking primarily for, say, long term dividend yield, will, paradoxically, be rather sensitive to the very next dividend.  Drop one and these "long term investors" will exit immediately.  It doesn't, however, take much math to see that in capital intesive R&D stocks you don't need a lot of growth expectation factored into share price before long-term growth prospects are the main driver of share prices, not this quarters earnings.  (Pharma is a good example here).

3.  The presence or absence of a "short-termism efficiency drag" has nothing to do with the question of unions, essentially a labor issue that exists no matter if the company is private or public.  To present the alternative to unions as the "tyranny of the quarterlies" is absurd.  This suggests to me that Ms. McArdle's commentator was really beneath her notice.  But, that was already beyond obvious here:

"Any individual corporation would be best served by a return to servitude (company towns, anyone?). The system as a whole may well be better served by having a systematic counterweight to maximizing short-term profits."

And again here:

"As you think about that, remember that there are other values in this world than maximizing short-term productivity, like treating people with dignity."

I will set aside, for a moment, the results of "company town" experiments like Chicago's Pullman district (though I think history suggests a conclusion very much at odds with the reader's romantic notion of such arrangements).  More important is the question of what the "other values" that it is appropriate for a corporation to adopt are.  It will doubtless come as no surprise to regular Going Private readers that I am at odds with the reader over the central question, which he (she?) obscures with the tyranny of the quarterlies miasma.  There is a very dangerous modern trend to hold the corporation (usually by tasking the Board of Directors) accountable to the "stakeholders" (which is code for "shareholders plus."  Usually, this starts off as "shareholders plus employees" but often progresses to "shareholders plus employees plus community" and eventually to "shareholders plus employees plus general public."  This ignores two key issues.

First, corporations are simply no good at philanthropy.  Nor should we want them to be.  The central point of the separation of ownership and control is specialization.  Giving to charity (and having ones gifts actually generate utility) is hard, laborious work.  Do we want management spending the time to do this work?

Second, assigning any responsbility to the corporation other than to make a profit for the shareholders (be that short term or long term) is very dangerous.  By what standard do we measure this obligation?  Is the corporation beholden to the employees to provide employment?  To the community to provide tax revenue and gainful employment to its residents?  If so, shouldn't we take all modern tools away from the employees and instead provide them with a dull spoon for all tasks?  Oh, I'm sure you might think that inefficient, but there are other values than the efficient direction of labor for the benefit of the shareholders- my dear friend.  Afterall, in order to maintain the production schedule its clients demand, the corporation would quickly be the largest employer in the state.  Now that sort of good corporate citizenship is hard to shake a stick at!

Tuesday, June 17, 2008

Obfuscation By Any Other Name

Mudd Alarmed at the implications of directing corporations to ultimately serve only those who actually provide the capital to fund their business ventures, Labor and Capital vigorously agitates the water in a frantic effort to stir the silt and augment the general leftist miasma required to form a left-favorable argument about the nature of the bottom of the river.  I've watched Labor and Capital warily for awhile, as surely its mandate, "...getting the labour movement and the Left to understand the capital markets properly," is beyond hopeless and therefore the author either an idiot (which would seem contradicted by the prose) or possessed of a dangerous agenda and very cunning.  This is my favorite part of the recent post:

Hence leaving 'shareholders' in charge of companies must be the right thing to do because they have the self-interested drive to keep them on the right track. It's an elegantly simple idea, but rather messed up by the reality. Hence the identity of shareholders is usually left vague.

Really, I haven't run across a more shortcut laden yet convoluted and obtuse bit of prose since Pevear started translating Tolstoy.  I am all for creativity in the written word, but this tendency to obscure basic meaning and torture interpretation in the pursuit of social-political goals must end sometime.  The definition of "shareholder" is quite simple.  Do you hold a share?  You are a shareholder.  Don't hold a share?  Not a shareholder.  Absolutely fucking brilliant, no?

I'm not even going to touch the part where it is argued that because a pension fund holds shares and a pension fund is "the public" that "the public" is a "shareholder."  My aversion there is pure self-preservation.  I mean really, where in the world could I ever take that argument?

Saying that anyone who has a "direct stake in the success" of a corporation somehow the corporation must be beholden to is beyond dangerous.  The IRS (and by extension the treasury) has a direct stake in the success of a corporation.  Is the corporation required to maximize the taxes paid by virtue of this "direct stake?"  Why not?  Same argument.  Ah, perhaps the IRS is just slightly less sympathetic a victim than the local union worker.  Yes?  Well, that particular sympathy should certainly bolster the argument's actual merits, no?

Interestingly, there are a few academic studies on the effects on union cohesion (and power) where corporations are more generious with their equity.  Amazingly, "pro-labor" initiatives of the sort advanced by unions fall flat on their face as employees have larger portions of their total compensation linked to equity.  Guess it doesn't seem so cool to commit massive amounts of capital to expensive, even ruinous (ahem, Detroit) defined benefit pension plans and headcount commitments when your financial future is actually linked to productivity instead of paycheck extortion.  I know it is hard to believe, but somehow it appears that incentives work.  Also, I believe the planet already tried out that whole "workers unite" experiment a few times.

Want to use your financial assets in a "socially responsible way" (whatever that means)?  Sell your shares and give the funds to the "socially responsible" chairty of your choice.  But then stay out of the damn shareholder's meeting.

Wednesday, December 24, 2008

Death of Cook

death of cookNormally, I am one of Barry Ritholtz’ fans, often indulging “The Big Picture”’s expansive prose and deft selection of this chart, that graph or the other political-economy cartoon that collectively has its finger right on the pulse of this week’s market week after week.  I fear, however, the tenure of my fandom is at an end, perhaps belatedly, now that I have absorbed his piece “RIP Chicago School of Economics: 1976-2008.”

Mr. Ritholtz’s Pre-Christmas missive gores Milton Friedman, citing a winding Bloomberg article by John Lippert, whose Chicago beat for Bloomberg often has him penning obiter dicta that includes the latest gossip relating to the Pritzker family, and their glowing approval at the selection of cousin Penny Pritzker as Obama’s national campaign-finance chairwoman, the climbing murder rate in Obama’s “backyard,” and the controversy over the Milton Friedman Institute at the University of Chicago.

The Bloomberg piece “Friedman Would Be Roiled as Chicago Disciples Rue Repudiation” might be forgiven the forced alliteration of its title (certainly I’ve penned worse puns during my tenure at DealBreaker), but granting it the status of some sort of indictment of the “Chicago School” is pushing very hard on the slack rope that is the article’s prose.  When the only real Friedman-indicting quote one can extract from University of Chicago faculty is from emeritus professor of anthropology Marshall Sahlins, who has, conveniently, rebelled violently against homo economicus for decades, it is difficult to find some revelation, some newly discovered and conclusive epitaph for Friedman therein.

Sahlins has much to lose in the homo economicus debate, as do most social scientists who struggle to salvage idealistic concepts about the self-determination of mankind, and its ability to shape itself through the naked will of cultural change alone.  (Certain European political movements in the not-so-distant past come to mind as apt comparisons).  A concept so crude as the economic self-interest of man might put to the torch the noble (and vanity appealing) idea that culture alone defines the stature of a people, after all.

Of course, in many instances the Sahlins school of thought results in rather more absurd intellectual cul-de-sac, drawing Sahlins himself into arguments rationalizing, for instance, the Death of Captain Cook via the necessity to recognize the unique cultural morays of the islanders who killed him.  Much simpler to just admit that Cook was an imperialist conquistador who bit off more than he could chew- but this would not allow for an expansive discourse on the otherwise marginalized relevance of the Lono deity cycle of the Hawaiian natives, an exploration of its importance in shaping modern history, the morality of Western claims of discovery, and the impact of culture clashes (or simply the boost to sales of Sahlins’ University of Chicago press publication on the topic).

If Cook himself prompted the fatal rage of natives, could their Lono deity cycle be of any interest?  What would this mean for cultural study, to reduce this shining example of the importance of cultural understanding (which may have saved Cook had he only appreciated the cultural proclivities of the islanders) instead to a tale of conquest, greed and the execution of imperialistic tyranny?

As an interesting aside, in 2004 when a piece thought to be the original “Death of Cook” by John Cleveley the Younger was discovered depicting Cook as anything but a peacemaker in the fray that eventually took his life, it struck a resounding and final note in that particular debate, as European painters and Western intellectuals had been attempting for over 300 years to recast Cook as something of an innocent in the events that lead to this death.  Perhaps this is one of the earlier examples of "white guilt," and being forced to admit that much of Western gains during the era were, in fact, the consequence of imperialist conquest was simply too difficult to face for the then cultural elite of the era.  It is significant, I think, that their reaction was so revisionist.

It is a common complaint echoed in criticism of these social sciences that they often engage in highly circular argumentation.  In the case of Sahlins that looks very much like “Assume the natives had a very unique perspective, since that would explain their actions in this case, they had a very unique perspective, and we cannot ignore their unique perspective- to do so would be to ignore the absolutely critical role of unique cultures in the understanding of reality.”

Uh, sure.

Unfortunately, the Sahlins approach also characterizes modern attacks on homo economicus and free markets.  At the heart of it, and my criticism, is what I can can only see as a worldview reminiscent of the Aristotelian-Ptolemian Earth-centric view of the cosmos, which is, not coincidentally, of similar psychological appeal.  This “homocentricism,” the concept that mankind has the ability to impose his cultural-moral will upon the environment wherever it chooses, is the master of his domain and is granted by divine right this power, is comforting and gratifying in that it suggests, erroneously in my view, that mankind has some agency in larger events.  It soothes and obscures the pain that is looking into the wide abyss of the cosmos only to come to the consequent realization that we are infinitely small, fragile creatures doomed to a cycle of consciousness under a century in length, of vanishingly small significance when compared to the time scale required to observe anything remotely interesting about the universe’s development.

As a species we can barely manage to protect ourselves from the flashes of temper of a planetary body characterized by phenomenal geologic stability compared to its cosmic peers (250,000 people on average lose their lives to natural disasters each year, events that also cost on the order of $100 billion per year) much less live long enough to escape the earth and reach out beyond anything other than the coldest, bleakest, emptiest space.  Of course it would be appealing that we might shape human interaction, the progress of nations and development (ultimately hinging on the effective and efficient allocation of resources) by will and intelligence alone.

Even this small measure of comfort, however, is a lie.

Coming, as this movement does, from the social science world, it can properly be viewed as an attempt to fill the void left by atheistic rationalism, at least insofar as that movement has gelded among intellectuals the soft comforts religion, or the belief in some grand design and larger purpose for mankind, formerly afforded.  Surely, then, there must be some foundation of thought to salvage the homocentric view of the universe?  Despair is a poor motivator, after all.

This urge, to find the agency of mankind, is compelling, and can be very, very dangerous.  In reality, however, there are no short cuts and homocentricism is a short cut, as is the reliance on culture as an agent of change.  I think, in some sense, this is a consequence of postmodern views of culture.  The “all expression is art, all expressers are artists” interpretation (one with which I violently agree in other contexts) also has the consequence of making all thought culture, and all thought worthy of attention.  Combined with the school of thought of, e.g. Sahlins, we are quickly thrust into a world where no concepts are irrational, inclusion is the most important feature and any hint of closed-mindedness is decryed.  The rise of the politically correct movements and the “tolerance at any cost” of multiculturalism (often flying in the face of all reason) presents a stark example of the effects hereof.

Paradoxically, any mass inclusion mandate has the effect of stifling any skepticism, even rational skepticism.  Criticism of any concept (no matter how absurd that concept) is framed as some form of bigotry or discrimination.  An attack on the belief systems of the holders of absurd thought.  Inter-tribal strife (even the modern version) is attributed to a lack of mutual understanding, and some fault on the part of the victim (the Captain Cook) for failing to understand the quaint, but critically important and valid beliefs of the perpetrators.  (Failing to accept the stoning of women for alleged adultery, for instance- or to respect the conquest driven precepts of certain interpretations of centuries-old religions).

It with this background that we arrive at Mr. Ritholtz’ piece.

Ritholtz’ principal claim appears to be that the Chicago School has been debunked, and its demise late in the coming.  Sayth Ritholtz:

A long Bloomberg piece, Friedman Would Be Roiled as Chicago Disciples Rue Repudiation, discusses the tarnishment of the Chicago school of thought.

Its [sic] long overdue. From the efficient-market theories, to the concept of man as rational profit maximizers, much of the edifice that is was the Chicago school of economics is based on a foundation that is false, disproven or otherwise questionable.

Ritholtz describes his introduction to neoclassical price theory, and classifies it as “authoritarian, a worship of a form of mob rule outside of the usual legal channels.”  He continues with:  “The view that regulation and other government intervention is always inefficient compared to a free market has now been made laughable.”

He then, disingenuously in my view, sets up his detractors thus:

Watch the comments for the cute little protests from law students who never practiced a day in their lives, and the biz school kiddies who never executed a single trade.

I had occasion to study with Fama, and Friedman, both skewered in the Bloomberg article, and while my law school experience seems long past, my business school experience seems less so.  Perhaps I meet Ritholtz’ pre-emptive definition of the trite detractor as a consequence, but it seems hard to take such ex ante ad hominem attacks seriously.  I suppose I expected more from Ritholtz.

This is not what agitates me about the Big Picture piece, however.  Rather, it appears Ritholtz has fallen prey to kind of the homocentric appeal that leads to arguments that free markets are some sort of authoritarian assault on what would otherwise be a fair and just democracy.  How else can we explain a line of argument that calls a “hands off” approach to economics “worship of a form of mob rule” and suggests them undemocratic and anti-representative?  It would seem Mr. Ritholtz’ would prefer a purely representative government.  One need look only as far as California’s recent passage of Proposition 8, amending the state constitution to ban gay marriage to realize that the gridlock of “absolute democracy” is folly, and that a pure democracy is far more authoritarian and reactionary than most dictatorships.  This is particularly so when the majority begins to realize they can vote themselves largess, collected by force, from the whole of society, all legitimized by the sanctity of “majority rule.”

Underpinning these lines of thinking is the absurd notion that individuals are entitled by right to happiness and prosperity.  That the role of government is to create fair results, rather than a fair system.  The United States Declaration of Independence itself managed to avoid this particular tar pit, and did so quite consciously.  It is the “pursuit of happiness” that is enshrined in that text.  It is due process that is afforded the individual, not a favorable process.

Perhaps Mr. Ritholtz, and modern free markets detractors, misunderstand what the Chicago School actually stands for.  Certainly, it was popular to paint the movement in draconian terms.  Friedman was, and still is, attacked rather viciously for his involvement in Chilean development during the tenure of Pinochet, but these criticisms misunderstand both Friedman’s involvement in Chile, and the nature of his belief in free markets.

If the Chicago School stands for anything it stands for the power of free markets to undo authoritarian political systems.  That Ritholtz gets this exactly backwards and then confounds his error so severely rises to the point of totally discrediting his missive.  Friedman pointed out that any economic system other than Laissez-Faire capitalism, of necessity, requires the use of coercion and force- not least to compel the collection of taxes.  He also pointed out that free markets, including the free movement of labor and goods, would always dissolve central control of economies, and make draconian leadership impossible.  To see Friedman’s espousal of these concepts in Chile as anything but his efforts to peacefully undermine statism and authoritarianism is akin to willful blindness.  Can we, after all, ignore the effect those forces had on the oppressive regime of the Soviet Union and the Warsaw Pact, both dismantled by free markets with barely a shot fired?  Friedman always stood for the premise that freer markets resulted in freer individuals.

Neither I nor Friedman have advocated anarcho-capitalism, though erecting this straw man is a typical tactic for Chicago School detractors.  Government clearly has a role in fostering fair markets, but beginning to make markets a little bit “more fair” for a particular constituency quickly exceeds the Chicago School brief.  This particular detail is often lost on Chicago School critics, as it is on Ritholtz.

Similarly, it has become fashionable to point fingers at people and (more disturbingly) at theories, like Black-Scholes (ironically both people and theories) thought to represent the Chicago School as responsible for the current collapse.  Eric Falkenstein “The World's Most Dangerous Mean-Variance Optimizer” nicely parries these attacks with specific reference to Nassim Taleb by wondering how we can any more blame Black-Scholes than the Fisher equation, or even rational thinking as a whole for the present credit crunch.

Moreover, blaming the current economic crash on the Chicago School is about as rational as chastising Shakespeare for Nicholas Hytner’s production of Henry IV.  The structure of the market in mid to late 2008 bore such little resemblance to anything the Chicago School represented that it seems near impossible to even mention the two in the same paragraph without straining the prose to such an extent as would grate even a Bloomberg reporter’s literary sense.  That hasn't stopped anyone though.  Consider:

In late 2007 we had billions upon billions of dollars flowing to prospective home-owner borrowers who, in any other circumstance, could not possibly have been thought worth the risk.  These outflows were facilitated by two massive entities, both seriously politically beholden to the legislature and stuffed with senior managers selected primarily for their ability to raise capital for political campaigns or otherwise service the then-current, ruling political class.  The pervasive and stated objective of these entities was to lower the cost, in the short-term, of “The American Dream of Home Ownership.”  Effectively, a group of legislators decided that home prices were too high, and lenders too risk averse and resolved to correct this "unfair" market result.  This they accomplished only too well.

The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 gave the power to dictate the particulars of home ownership incentives that would bind the GSEs to the Office of Federal Housing Enterprise Oversight, created within the United States Department of Housing and Urban Development by the same act.

Step back and consider this for a moment.

Billions of dollars was forcibly injected into the housing market for the least qualified borrowers in the form of massive and artificially created demand from Fannie and Freddie as dictated by the wisdom of less than a dozen senior members of the political class in the United States.  In 1996 that amounted to $48 billion in mortgages for otherwise unqualified borrowers that probably would not otherwise have been written.  By 1999 Freddie was penning deals to be the exclusive purchaser of loans written by third parties (Norwest was the first such entity).  Underwriting standards, and their natural check on risk, were never to be particularly connected to the mortgage process again.  This was hailed as a great victory for the Dream of Home Ownership.  By 2000 HUD set Fannie and Freddie to purchase $2.4 trillion (that’s not a typo) in low-grade loans over the next 10 years with significant penalties if they failed.  The GSEs knew the fist of an angry legislative god would descend upon them like no fury they had heretofore experienced if they failed in their appointed task.  How do you think they reacted exactly?

Step back and consider this for a moment.

A small administrative cadre was centrally setting the level of demand and liquidity flow for a major portion of the country’s economy, and, in a cruel multiplier effect, was therefore indirectly setting prices that influenced all the actors in that sector.

By the end 2000 GSEs held 1/3 of all multi-family mortgages.  The speed alone by which these entities captured a 33% market share of a multi-trillion dollar market should have raised eyebrows.  Does anyone really think this possible in a business formerly posessed of such slim margins without a major market distortion?  By now both GSEs were also buying “NINA” loans.  (No income, no assets).  No, I’m not kidding.  That too was mandated.

It bears mentioning during this period that competitors, unable to function in a market this skewed, complained bitterly that the GSEs were distorting their ability to profit, and that they were, in effect, using government subsidies to advertise their services to prospective homeowners.

Let’s put this into perspective.  In what other context would any system calling itself a "free market" ever permit this?  What would we think if the United States government poured advertising dollars into a government sponsored entity producing computer operating systems in direct competition with Linux, Apple and Microsoft?

Those protesting were shouted down with the rationale that the advertisements were not direct to consumers, but rather merely there to educate consumers about the mortgage process, and that the detractors were only looking to increase the cost of home ownership (which, in fact, they were).  No, I’m not making this up either.

The GSEs going public exaggerated the results.  The likes of Countrywide now had to compete with Fannie and Freddie for investor capital.  Their own returns on equity would now be held up to the skewed standard of the GSEs, which showed greater than 20% returns on equity for almost two straight decades, fueled by ever increasing mandates and capital to buy-buy-buy the worst mortgages on the market.

Unsurprisingly, the risk models employed by non-GSE firms made it difficult if not impossible to make a buck when the GSEs were siphoning off anything and everything at reduced rates.  To compete in the distortion, firms like Countrywide resorted to rather creative tactics.  Countrywide Mortgage Investment was created by Angelo Mozilo, for instance, to collateralize Countrywide Financial loans outside of the mortgage size bands dominated by Freddie Mac and Fannie Mae.  Mozilo and Countrywide can hardly be blamed.  Unable to compete in any market where Fannie and Freddie were participating, their business had to evolve into something different.  CMI later evolved into the failed IndyMac, whose abysmal standards for lending have now become the subject of FBI investigations, ironically for doing exactly what the legislature was mandating the GSEs to do, ignore underwriting standards to boost low-income home ownership.  IndyMac took it somewhat further, and forged documents, among other offenses, or did they?  Do we really think no one in the underwriting department of the GSEs did the same?

Post 2000 and 2001, in an environment of historically low interest rates, the impact on the housing market, particularly the low end of the housing market, was predictable.  It ballooned.  The primary cause for low interest rates?  Another anathema to the Chicago School, intervention by the Federal Reserve to recover from the dot-com collapse and 9/11.

As a consequence of the boom, GSEs, and everyone else, had to put all the mortgage paper somewhere.  Technically, their mandates ran afoul of capital regulations.  There was literally no way that the number of loans they were being compelled by statute and the regulatory urgings of HUD to buy could be kept on their own balance sheets.  That should have been the cap right there.  And if not for the dire consequences of missing their targets, it might have been.  There is only so much mortgage risk you can keep on your balance sheet with the capital requirements then in place.  They were eased repeatedly, but not enough to allow the GSEs to satisfy their political masters.  Eventually, they would run afoul of the simplistic regulatory capital requirements that burdened them.  Enter Wall Street.  "Of course, we can solve that problem."  We will just securitize it all.  Faced with daunting requirements, Fannie and Freddie had little choice, and, therefore, either did anyone who had to compete with them.  It should be pointed out that this, in itself, was entirely within the sort of conduct permitted by the regulation of the time.

Here is where the story seems to throw otherwise rational thinking beings: The market was doing exactly what it was supposed to do at this point.  Exactly what it was supposed to.

You had legislators and executives from both parties (Newt Gingrich was an adviser to IndyMac, for instance) telling the market “I want a huge spike in debt-funded home ownership for low income households short-term, and here are positive and negative incentives to accomplish that.”  The Federal Reserve is telling the economy “Nope, nope, no recession today.  I want lots of borrowing, and, since I’m making your returns of safe instruments vanishingly small, I want that cash to flow into more speculative instruments.”  Paradoxically, regulators were also telling everyone in the market “You better watch how much risk you hold in any one entity.”  The market dutifully complied.  Homes “owned” by poor quality borrowers skyrocketed in the short-term, just as our brilliant leaders wanted them to.  Underwriting became divorced from the mortgage writing process because none of the incentives created by government intervention rewarded careful underwriting and several incentives created by government intervention explicitly penalized careful underwriting.  What exactly did everyone expect?  Disneyland?

It is telling that Barney Frank seems to have emerged as one of the leading central controllers somehow qualified to save us all from this mess.  That Congressman Frank is enjoying anything other than ignominious ostracization as an utterly failed and deposed elder statesman for his role in destroying the mortgage economy and everything connected to it (i.e. everything) is a testament to the inability of society to select competent leaders.  This, in itself, should serve as a cautionary tale to Chicago School detractors.  Alas, denial ain’t just a river in Egypt.

It should also be recognized that when individual entity risks started to escalate, the market, again, did exactly what it was supposed to do.  Exactly.  It created mechanisms to transfer that risk from risk averse entities (that aversion artificially mandated by unsophisticated risk and capital limitations) to risk seeking entities in the form of securitization.  And when clever Wall Streeters realized that 200 pieces of mortgage paper rated B could be mashed together and their lack of default correlation would permit the likes of Fitch, Standard and Poor’s and Moodys to throw a AAA rating on the aggregate, well, the market was doing just what we told it to- considering we required large institutions to meet particular credit standards in their portfolio, and because we measured those standards by the woefully inadequate analysis pawned by the ratings agencies.  Specifically: a centrally mandated metric for risk, created by the legislature and enforced by regulators, specifically: the blessing of the ratings agencies, was the centerpiece for evaluating the risk in institutional portfolios.  Make no mistake, the regulation of the day not only endorsed reliance on the poor models employed by the ratings agencies, it mandated it.  In retrospect, could anything look more daft?

The entire system was geared to spike home ownership among poor quality borrowers in the short term and delay any reckoning as long and as completely as possible.  Further, it was designed by the legislature with woefully simplistic measures for risk and utterly naive means of enforcement.  The entire premise was the vain search for a free lunch.

Not only does the Chicago School not shoulder any of the blame for this travesty, but even the most basic student of the Chicago School and neoclassical pricing theory could have predicted it without breaking a sweat.

I’m no PhD candidate, but I was musing about the liquidity surge and its likely effects, twice as far back as March, 2007, and again in August, 2007 (I even quoted a comment left by a The Big Picture reader in that piece) and yet again in September, 2007:

First, as liquidity pours into opportunities, the number of favorable risk-reward opportunities dries up, pressing liquidity ever lower on the risk-return scale.  Second, as asset prices are driven up by the competition for assets, the returns available to higher risk assets diminish.  (The risk premium narrows).

These two effects drive liquidity seeking the same level or returns into increasingly risky assets.  These effects are, as I pointed out, complicated by the structural need for particular risk tranches to service structured products or the issuance of instruments in securitization transactions (CDOs and such) that depend on efficiency frontier portfolio design.  These instruments can, therefore, create an "artificial" need for high risk assets and drive these asset prices up, even as their quality diminishes.

In the present example, and in the words of a CDO manager I quoted before: "I gotta keep accumulating collateral, and I gotta issue the liability against that collateral."  This, in turn, drives loan origination into overdrive and so reduces the oversight and loan standards that less than qualified borrowers are given a pass where they otherwise never would have.

I closed the August piece with this:

What are the lessons for the Going Private reader?  The combination of unaligned incentives (both on the intra-institutional and inter-institutional level), overheated first order liquidity (cheap cash), fickle second order liquidity (as distinguished from true liquidity), and a time lag between liquidity supply and performance feedback for that liquidity, should present strong, structural arguments that, when carefully examined, result in legions of smug looking Going Private readers sunning themselves while floating on liquid(ity) in their new yachts.

Again, I don't make the case here that I am some genius investor.  Merely that even a young girl with a newly minted MBA, a student of the Chicago School writing a private equity blog in her spare time could see what was happening.

Clever investors (e.g. Paulson & Co.) took the time to dig deep into the structures and made small fortunes allocating capital effectively as a result of the crisis.  Of course, these investors, the only ones actually exercising any intellectual calories, are now symbols of the evil profiteering of otherwise innocent market actors.

Now, what sort of myopic intellectual arrogance does it take to blame the results of this borderline criminal bit of statism on the facts that Moodys, Standard and Poor’s and Fitch used Gaussian distributions and correlation modeling to assign their ratings, and that these ratings were the crux of regulatory requirements on institutions?  Well, I submit, the kind of myopic intellectual arrogance that Mr. Ritholtz’ piece displays.  At the heart of it is the conceit that we (the United States) can tame the cycles of the market with the force of our will.  That if only we had the right leaders, these crises would be avoided.  If only we hadn’t deregulated so far.  Of course, no proponent of these positions seems to have any real grasp of how regulated and artificial mortgage markets were at this point- but that takes some work to uncover through the miasma that is today's political rhetoric on the subject.  That, in short, is too much work to try and understand.

The belief that we can reject the cold hard reality described in neoclasical price theory and therefore the Chicago School for a much warmer, fuzzier world is a very appealing one.  We would love a world where we can spike low-end home ownership at will.  Where anyone can enjoy the two car garage stuffed with a pair of new SUVs, and the adjoining macmansion adorned with numerous flat screen TVs, unlimited cable and a perfectly manicured lawn.  Where everyone can live outside their means indefinitely.  Where everyone has a right to insurance.  Cheap insurance.  Where everyone can build inside the bounds of a 50 year floodplain, demand “affordable” insurance for their delusional misunderstanding of their place in the natural world and look to the rest of society to compensate them if the insurer’s premiums (regulated by state mandated risk models to keep them low) are insufficient to cover the rebuilding bills.  A world where 30 minutes study is all that’s required to invest your life savings in a single instrument you selected after reading a glossy brochure on the premise that it is your god given right to make 14% annual returns, and where making a poor selection in that due diligence process is cause for your immediate bailout.

And this is the world that the anti-Chicago School desperately needs.  The world where investing isn’t hard.  Where there is an entitlement to returns.  Where, rather than do painful fundamental analysis, we can rely on simple models that tell us with flawless precision to invest every single dime of our capital in the care of the greatest Sharpe ratio known to man (Bernie Madoff).  Or on three-letter ratings from this or that agency.  In short, a life that rewards intellectual laziness lavishly.  After all, if the world is cruel and cold, and humans are powerless to sway the tide, then what role is there for great leaders?  Great leaders to bring us limitless and effortless prosperity.  Great leaders to punish the evil-doers who gave us imperfect models with fines, perp-walks and, yes, prison.

And this is the ultimate danger of these lines of thoughts.  To adopt a theory that central control of economies is effective, one must believe in omniscient central controllers.  This leads nowhere other than to a cult of personality and unfaltering belief in a perfect leader who will tame markets, be he named Marx, Reagan, Greenspan or Obama.

It is the dogged skepticism of the Chicago School that results in its opposition to such notions.  But, like other criticisms of homocentric thinking, it is doomed to be attacked and decried with the sort of criticism that populists often take advantage of: It is cold-hearted and unmoving.  It requires of us real work.  It requires us to admit that capitalism is hard.  That there are no free lunches.  That merely voting for the right leader and hoping for the best is not sufficient.  And, like the Copernican model, which should have put forever to rest the notion that mankind is the center of the cosmos, it fails to give mankind’s vanity its due.  Copernicus was infinitely lucky not to live to see the publication of his works as he no doubt would have been killed for them.  It would be a pity if the same might be said of Friedman in twenty years.

Our need to remake Cook, rather than face the baser reality of the time in which he lived, and the fact that his conquests, and those of adventurers like him, most likely resulted in more efficient allocations of resources and in large measure the historically remarkable prosperity we now enjoy, is both understandable and dangerous.  The same can be said of the propensity to demonize models in a vain attempt to soften the world.

When I was learning about Gaussian distributions my professor admonished us after every example he gave.  “Do not use this blindly in the real world.  It will turn around and bite you.”  Gaussian distributions were useful much of the time, he warned, often enough to lull you into a false sense of security.  The real world, he cautioned, looks far more like hydrodynamics, and wave theory.  Guided most often by Gaussian distributions, enough so to allow prediction accuracy 99% of the time, until chaotic seas make nonlinear Schrodinger equations more apt and (out of "nowhere") a rogue wave sinks your 99th percentile hull design as easy as you crack an egg for breakfast.  The world was likely overlaid by more than one model, he suggested.  One, which rules most of the time, calmly predictable and familiar, and one (or many) that lurked just beneath, waiting to show itself in all its fury when conditions were right.  Woe to the practitioner who failed to heed this warning, one he echoed for the nth time, sternly before the final (one of my last).  That practitioner is doomed.

That professor, by the way, was Eugene Fama.

Art Credit: John Cleveley the Younger "Death of Cook," (1784) National Maritime Museum, London.  (Discovered, 2004 in private British collection).

Thursday, January 29, 2009

The Occasional Solace of Hate Mail

it came in the mailI often quip that reader mail is one of the things that keeps me blogging.  It is, but sometimes not in the way that I would expect.  Going Private has in past, and continues to be, an occasional lightening rod for some of the more spoiled of capitalism's children.  Insofar as much of my writing centers on the fact that there is no such thing as a unicorn that defecates skittles, the delicate sensibilities of many a market-must-go-up-at-any-cost "capitalist" are torn asunder.  This provokes a good deal of amusing (if not particularly illuminating) hatefan mail, written, doubtless, on a high end PC with 30" flat panel monitor bought on credit.  I suppose the consoling feature of letters like these is that they suggest that the enemies of capitalism are mostly a poorly read collection of rabble, confined to intellectual debate on the level of "you are an idiot."  If this is true, there may be hope yet.  I can only guess that the urge to mail things like this to me is very much like the religious types who promise me "I will pray for you," upon learning that I think their anthropomorphic vision of god is a freshly steaming load of unicorn skittles.

Acting on the theory that these works, and my replies to them (which, fortunately or unfortunately, tend to sink somewhat to the level of the original author), have some entertainment value, I reproduce for you one of the most recent editions to my collection of trite hate mail (and the reply thereto):

On Thu, 29 Jan 2009 09:47:08 -0600 Paul <[email protected]> wrote:

Just wanted to say I just read your blog post "Death of Cook" and I found myself feeling a bit emotional afterward. 

I admired very much the point -- which I think hasn't been made nearly enough in this debate -- that Friedman's key insight was that freer markets bring power to keep repressive regimes at bay, of from forming in the first place. 

But now that entire economic world has collapsed, leaving the Chicago School with as much credibility as the alchemists or the flat earthers or Phil Gramm, it must be so difficult for the devotées such as you to deal with the fact that what you've studied and come to believe in is now just so much intellectual rubble, which no amount of desperately grasping at any government entity you can to try to hurl blame at, as you do with Fannie Mae or the Fed, can make go untrue. 

Or as PK puts it, now that you've paid your tuition, you've learned you've invested your education with Bernie Madoff.

It's palpable in your post how bitter you are.  I'm genuinely sorry about that, and only hope that as you move on in life, you can find somewhere to utilize your talents in a less futile way than defending the decaying corpse of a dead School.


Dear "Paul" (who signs his emails with "-L"):

Your email is long on glib cliche, very short on fact and totally lacking in analysis.  While I am not sure if these effects were intentional (at first I thought your piece a clever bit of satire, until I got halfway in) they do make your writing remarkably unremarkable in the way it absolutely typifies comments of this kind.

While I understand that attacking markets and finance is what all the cool kids are doing today, doing so with something that approaches compelling and reasoned argument is (as you demonstrate here) rather more difficult.

The fantasy that the markets that melted down were anything remotely resembling "free markets" has created a lot of masturbatory material for the new socialists (and worse).  It is, however, totally divorced from fact and as a consequence you might have to work to get some of that genetic material out of your hair.  (I'm told baby shampoo works wonders).  Given that you fail to address these aspects of my missive (odd since I spent a lot of time and "ink" outlining them) I must conclude that you either:

1.  Have limited reading comprehension skills (public schools perhaps?);
2.  Did not read the piece in any detail (ADD?); or,
3.  Have avoided these points because they derail your position (basic cowardice).

None of these bode well for your intellectual prowess.  Or maybe you were just too lazy to pen a thoughtful reply.  It is, of course, a great conceit to cram useless blather into the inboxes of strangers.  It is a bit of time hijacking.  Be that as it may, I try to reply to such nonsense where possible.  Call it a weakness I have: the inability to pass up the opportunity to discipline other people's insolent children.

If the most fundamental misunderstanding of the issues at hand here were not enough, you attribute to me views which I do not hold, positions I have not defended and associations I do not maintain.  This, given the tenor of the rest of your note, doesn't really surprise me.

I am indeed, as it happens, bitter.  Bitter to watch the new political class rise to power in a miasma of anti-capitalist rhetoric, to watch the renewed belief that the correct "super men" will fix the problem by adjusting the levers of the economy to suit them (as if this hadn't caused the crisis in the first place) and the cult of personality that accompanies such fantastic and feverish belief.  (Already members of the Cabinet are forgiven their felonious transgressions because there is "important work to be done").  In a sense, your prose here is a perfect example of this twisted mindset.  You attack a school of which you demonstrably have little or no understanding, and rely on cliche and stereotype to brand those with views divergent from your own.  In short, you have no meaningful intellectual insight whatsoever to offer.  That you are typical of what lurks out there in the dark, vengeful and misguided malice of public opinion does leave me bitter.  Bitter, and revolted.

But, thankfully, there are tools like the NASDAQ index of bailed out companies, credit default swaps, short selling and put options so that those of us paying attention can bet heavily against this new regime (and by this I mean both sides of political system), and, sadly, against the prospects for the United States for the next five years.  So far that's proving among the most profitable of endeavors, even matched against the obscenely high remuneration of Private Equity.  If you had really been reading my stuff for some time you would have noticed that I saw the train coming back in 2007.  Many of us did.  At the time I invited readers to bet against the system.  I hope some did.  You, clearly, were not among them.

Yes, I'm afraid the palpable glee for the misfortune of finance professionals- that jealousy driven joy that literally oozes from your prose like so much thickened bile, is also based on a fantasy: that I join the many bankers and finance professionals who languish in the aftermath of heavy handed government intervention in the real estate market.  Some of us, you see, saw it coming.  Some of us, you see, do not now live in oversized and now negative equity homes for which we overpaid at the height of the market with easy credit.  Some of us didn't surround ourselves with flat-panel displays bought at the expense of large balances on 18.5% APR credit cards.  Some of us, in short, were paying attention.

Interestingly, no one had many complaints about Wall Street, or the like, when they could buy $750,000 in house at 6.2% with $60,000 in income.  You enjoyed with great enthusiasm the trappings of the bubble on the way up, so it is not surprising that you will point anywhere at all to avoid looking in the mirror now that it is on the way down.

It is good that you seem to enjoy the way of things to come, because you are going to be enjoying them for a long time.  Not so for those of us who planned carefully and have carefully collected the wherewithal to leave, if (god forbid) it should come to that. 

Yes, it is good that you seem to enjoy the new socialist paradise that awaits you- because you are going to be stuck with it for some time.

Thanks for taking the time to write.  Reader mail is what reminds me that the blog is worth writing.


Thursday, February 05, 2009

Dare Ye Inquire Concerning Such a Wretch?

out of harms way I have always had a certain unquenchable lust for the lost works of Sophocles, member of The Three, and of whom only seven works survive the looting of the Library of Alexandria- though we have cause to believe he crafted many, many more.  I like to think some nimble librarian, or patron of the library stole away to the shelf where his works were kept and slipped away with just as many (seven) as he could fit in the folds of his clothes.  But in this, I am likely a romantic.

His most recognized works, marvelous as they are, will forever be incomplete as they represent single samples of his four volume treatments.  Before the world of finance, when such things were more apt to cause me wonder, I thought after what other commentary on sovereignty, The State and power we might have seen from this great tragedian, if only his other works were available to us.  Freud notwithstanding, Oedipus Rex is, after all, primarily about The State, power, executive arrogance, willful blindness and the consequences thereof.  But, and this is key, I think most of all, Oedipus Rex is about a total disregard for the inevitability of reality, and, it is this point, as it happens, that leads me to my present subject.

I find it intensely interesting that a number of commentators have alternately attempted to blame and exonerate the Community Reinvestment Act (hereinafter the "CRA") for complicity in the alarmingly complete inflation of the real estate bubble and, in effect, the current credit crisis.  It takes only a few readings of the most prominent (or at least the most prolific) of these authors to discern a woefully inadequate coverage of the context and history of that act, its predecessors, and the regime of mortgage regulation that they spawned.  This particular perspective, that is to say the stubborn focus on a single piece of legislation in the midst of a vast and interlocking series of statutes, rules and regulations ceaselessly built up over three decades, permits the easy (and, indeed, somewhat smug) dismissal of the CRA with the continually repeated line: "The foreclosure statistics do not support such an argument."

Early on in the development of my thinking in this area I wondered why foreclosure statistics should necessarily falsify the thesis that the CRA (or the twisted, multi-branched family of mortgage regulation that preceded and accompanied it) bears some of the responsibility for the present malaise.  We do not, after all, have to write a mortgage down to levels even remotely near salvage cost to see tremendous losses once it has been securitized.  This becomes particularly obvious when we remember that, prior to about eighteen months ago, mortgage backed securities were generally regarded with Madoff-like confidence.  Any break from the norm would easily cause a panic.  Could, therefore, a pool of mortgages suffer from such a serious confidence blow that their value would be written down to pennies on the dollar without the consummate spike in foreclosure rates?  To what extent would pools of low FICO loans be written down independent of any reference to foreclosure rates?  Surely, wise investors will use the only real metric they have for the cash flow prospects of these assets: the borrowers' ability to repay, no?  In this connection, insofar as every piece of historical data about foreclosures seems to have been fairly useless in averting the present crash, how likely are current or past foreclosure figures to have any impact on careful students of this market?  None, I would argue, where smart players are looking to guess where the next spike in foreclosures will hit.

This question only served as the seed for a different question: How did we come to find ourselves in the molasses-like regulatory pool in which we presently swim?  What came before during and after Fannie and Freddie?  When did it become so routinely fashionable to tamper with the mortgage market that, even when shown the facts as plain as day, otherwise bright and skeptical minds refuse to see any issue with an entirely backwards incentive and capital structure developed over thirty years by the legislature of the United States?  Alarmingly, there was very little work on this topic to be found.  That too made me curious.

It turns out it all began in the 1960s, with a series of slow changes that, typical of the beginnings of massive upheavals, passed unnoticed.  What followed in the 1970s and particularly the 1980s was a literal hockey-stick curve of mortgage regulation, legislation, incentives, grant programs and the seeds of a centralized financial-industrial lending policy that brought us to where we are today.  Make no mistake, there is no simple cause for the present crisis.  There were, however, simple seeds.

To be certain there is much blame to go around.  This author will attempt no defense of the various "big banks" that participated in the fiasco that is our current real estate market.  Be this as it may, it bears mentioning that no one was complaining fifteen or even twenty years ago, when the trouble started.  Banks are only the most visible and current culprits. Their bad tidings, however, would not hardly be interesting but for the worst laid plans carved laboriously out of the wood of populist pandering for more than twenty years.  Unfortunately, now the flames of said pandering have been fanned, and today apparently we think that forcing Citi to break their $50 million contract for delivery of a Dassault Falcon 7X in some kind of pathetic retroactive spanking delivered by this nation's chief executive behind the Congressional woodshed, makes some kind a difference.  (I suppose, however, Citi could at least have bought American and acquired a Gulfstream).

If you are looking for big catalysts, and most astute Going Private readers are, there are a number of fairly convincing candidates.  To understand how big, however, one must understand the nature of the environment before The Community Reinvestment Act.  What no one bothers to mention today is that the CRA broke the firewall of a long trend in the regulation of mortgage lending in the United States.  Prior to that act, legislation like Title VIII of the Civil Rights Act, the Fair Housing Act of 1968 and the Home Mortgage Disclosure Act of 1975 focused on the prohibition of rank discrimination and used disclosure as a means to impose fairness on the mortgage market.

Without a doubt, these were areas that needed addressing, and for the most part, I find the means these statutes employ reasonable and appropriate.  In fact, it doesn't take long to see that the Home Mortgage Disclosure Act of 1975 looks nothing like legislation when viewed through today's frosty glass.  Consider:

The Congress finds that some depository institutions have sometimes contributed to the decline of certain geographic areas by their failure pursuant to their chartering responsibilities to provide adequate home financing to qualified applicants on reasonable terms and conditions.

The purpose of this title is to provide the citizens and public officials of the United States with sufficient information to enable them to determine whether depository institutions are filling their obligations to serve the housing needs of the communities and neighborhoods in which they are located and to assist public officials in their determination of the distribution of public sector investments in a manner designed to improve the private investment environment. (12 USC § 2801).

The act continues:

(1)  Each depository institution which has a home office or branch office located within a primary metropolitan statistical area... shall compile and make available, in accordance with regulations of the Board, to the public for inspection and copying at the home office, and at least one branch office within each primary metropolitan statistical area... in which the depository institution has an office the number and total dollar amount of mortgage loans which were (A) originated (or for which the institution received completed applications), or (B) purchased by that institution during each fiscal year (beginning with the last full fiscal year of that institution which immediately preceded the effective date of this title).

(2)  The information required to be maintained and made available under paragraph (1) shall also be itemized in order to clearly and conspicuously disclose the following:

(A)  The number and dollar amount for each item referred to in paragraph (1), by census tracts, for mortgage loans secured by property....

(B)  The number and dollar amount for each item referred to in paragraph (1) for all such mortgage loans which are secured by property....

(Much detail about statistical area definition elided)

The act goes on, in typical legislative fashion, to describe in detail at once great and burdensome, the various definitions and requirements and accessibility issues surrounding these disclosures.

It is pretty hard for any libertarian or otherwise free-market-disposed party to argue against this sort of thing.  Perhaps one might make the argument that market information is being disclosed to competitors, but really, and particularly in the context of 1975, this is a difficult position to cling to without a certain amount of self-deception.

I also want to highlight part of the finding of the Congress used to support the passage of this legislation.  Specifically:

The Congress finds that some depository institutions have sometimes contributed to the decline of certain geographic areas by their failure pursuant to their chartering responsibilities to provide adequate home financing to qualified applicants on reasonable terms and conditions. (Emphasis mine).

Everything you ever needed to enforce equality in lending is contained in this simple description.  I submit that, despite the fact that the "Finding and Purposes" section of most legislation is fluff, a lot of thought went into this particular passage.  Or, alternatively, the importance of this sort of thing simply occurred more readily to the Congresses of old- 1975 seems very old to me, your mileage may vary.

Consider the components here:

1. Adequate home financing...
2. qualified applicants...
3. ...on reasonable terms and conditions.

This is pretty reasonable stuff, really.  There is a particular genius in public disclosure and transparency statutes, sunlight being the best disinfectant and all.  It recalls a period, some years before my birth, where there was a sort of basic trust that, once exposed to the hot glare of public scrutiny, market actors would clean up their act.  Government had to do little.

I think this very artful and elegant. Unfortunately, we have come a long way since 1975.

Enforcement for the act was provided for directly in the statute.  To wit:

For the purpose of the exercise by any agency referred to in subsection (b) of its powers under any Act referred to in that subsection, a violation of any requirement imposed under this title shall be deemed to be a violation of a requirement imposed under that Act. In addition to its powers under any provision of law specifically referred to in subsection (b), each of the agencies referred to in that subsection may exercise, for the purpose of enforcing compliance with any requirement imposed under this title, any other authority conferred on it by law. (12 USC § 2807).

Responsibility for promulgating regulations related to the act ultimately fell to the Federal Reserve Board.

Again, this is pretty reasonable stuff.

There are some other interesting provisions, including the requirement of an annual report to Congress on the utility of the effort (12 USC § 2801) and a requirement for the aggregation of the data (12 USC § 2809).

In essence, the statute was a fairly obscure reporting statute known intimately only to the growing breed of back office administrators we would today recognize as "Compliance Professionals."  Its effect was less obscure.  While the average man on the street might have been unaware of its existence, interested parties, in particular activists concerned with civil rights, now had the tools necessary to crunch data and root out discrimination in effect (if not discrimination in intent).  The phrase "The data in the study come from the Home Mortgage Disclosure Act" is so rampant in the relevant literature today it seems obvious what impact the statute has had.  A quick cross-reference search of the "Home Mortgage Disclosure Act" and the name of any prominent civil rights leader makes it obvious that the data liberated by the act became the go-to ammunition for taking on lenders.

In this connection, there is no doubt that the practice of "redlining" (named for the unfortunate map fallen into the hands of investigators that outlined in red the areas to which a financial institution which shall remain nameless would not lend under any circumstances) was a serious issue at the time.  Ironically, however, we have come full circle and then some.  Cases like Hargraves v. Capital City Mortgage Corp. (140 F. Supp.2d 7 (D.D.C. 2000)) have successfully argued against "reverse redlining," wherein courts have held that artificially pumping funds into a given area on the basis of race (perhaps with the expectation of forcing foreclosure) is, in fact, "predatory lending" and just as bad.  Of course, we have the Home Ownership and Equity Protection Act (15 U.S.C. § 1639) to eliminate this practice.  No word yet on its success.

One cannot help but feel a little sorry for the General Counsel of a mortgage lender at this point, situated as she is between a legislative rock and a judicial hard place.  This quote from Hargraves is priceless:

Redlining creates the market conditions in which reverse redlining thrives. It should come as no surprise that the United States recently settled a case charging Chevy Chase Federal Savings Bank with redlining the exact areas that Defendants are now accused of targeting for predatory lending (140 F. Supp.2d 7 (D.D.C. 2000)).

Observant Going Private readers may point out that once you legitimize the practice of legislative underwriting, the regulatory world and the slings and arrows of the tide of public opinion get intensely confusing, and fraud works easily in both directions.  An astute practitioner once told me "fraud expands to fill the envelope," meaning that such schemes are ever-present and, like expanding gas, always pushing gently to discover the limits of their freedom.  Another friend of Going Private, a former counter-narcotics analyst, put it much more succinctly.  "We are just squeezing the Jell-O."

I will hardly argue that Hargraves was wrongly decided.  I merely note that the dilemma Congress has created solves few of the issues of the day and creates parallel problems just as bad, if not worse.  Rather, most certainly worse.

But, context being critical to the discussion, let us dial the Wayback Machine to 1989.  1989-1990 was an amazingly prolific period for federal intervention in housing and mortgage matters.  Right next to the Global Warming Prevention Act of 1989 even the most cursory of searches returns a literal spew of bills including:

The HUD Reform Act of 1989: To ensure competitiveness in procedures for approving applications for housing assistance and to provide for refinancing of mortgages, loans, and advances of credit under the lower income homeownership program of section 235 of the National Housing Act.

The Homebuyers and Renters Relief Act of 1989: To increase the affordability of homeownership for first-time homebuyers and promote the development of low-income rental housing.

The Housing Opportunity Zones Act of 1990: To remove legislative and administrative barriers to the production of new and substantially rehabilitated housing that is affordable to lower-, moderate-, and middle-income families.

The Department of Housing and Urban Development Accountability Act of 1989: To prevent abuses of the process for selection for housing assistance under programs administered by the Secretary of Housing and Urban Development.

The Community Housing Investment Partnership Act.

The Recycling of Existing Assets for Cost-Effective Housing Act of 1989: To authorize the Secretary of Housing and Urban Development to make grants to States to establish revolving funds to assist low- and moderate-income homebuyers and renters.

The Low-Income Housing Credit Act of 1989: To amend the Internal Revenue Code of 1986 to improve the effectiveness of the low-income housing credit.

The Low Income Housing Preservation Act of 1989.

The Housing Affordability Act.

Homeownership and Opportunity for People Everywhere Act of 1990 (The "HOPE" Act).

Really, who could vote against this?  Consider:

"There are authorized to be appropriated for grants under this title $96,000,000 for fiscal year 1991, $260,000,000 for fiscal year 1992, and $400,000,000 for fiscal year 1993. Sums appropriated pursuant to this subsection shall remain available until expended."

The more observant of Going Private readers will expect the re-introduction of the HOPE Act any day now, submitted, no doubt, concurrently with the Community Housing Affordability and No Gains to Equity Act (the "CHANGE" Act).

Fair Lending Enforcement Act of 1990: To amend the Equal Credit Opportunity Act and the Home Mortgage Disclosure Act.

The Housing and Community Development Act of 1989.

The Housing and Community Development Act of 1990.

The Community Housing Investment Partnership Act.

The Homeownership Assistance Act of 1989: To authorize the insurance of certain mortgages for first-time homebuyers, and for other purposes.

The Home Mortgage Overcharge Prevention Act of 1989: To amend the National Housing Act to limit the amount of interest paid by a homebuyer upon the prepayment of a mortgage insured under the Department of Housing and Urban Development single-family mortgage insurance program.

The Neighborhood Mortgage Lenders Accountability Act: If any examination of an approved mortgagee by the Secretary (including an examination under subsection (d)) discloses that the mortgagee has failed, in the determination of the Secretary, to meet the lending needs of the community served by the mortgage (as determined by the Secretary under subsection (a)(1)) with respect to residential housing lending, the Secretary may, in the discretion of the Secretary, require that the mortgagee, for continued status as an approved mortgagee for purposes of this Act, develop and submit a plan for remedying such deficiencies.

This bill should ring some alarm bells:

The First-Time Homebuyers Assistance Act of 1989: To authorize the Secretary of Housing and Urban Development to establish a demonstration program to insure mortgages with no downpayment for moderate-income first-time homebuying families.

But, I think it is this bill will likely be the favorite of the typically irreverent Going Private reader:

The Homeownership Through Sweat Equity Act of 1989: To authorize the Secretary of Housing and Urban Development to carry out a demonstration program of providing grants to housing development agencies to acquire abandoned and vacant housing for rehabilitation and rehabitation by homeless and low-income families.

And finally (take note here):

The Fair Lending Oversight and Enforcement Act of 1989: To require lenders to compile and make available mortgage loan and commercial loan information necessary to assess compliance with nondiscrimination requirements.

Granted, most of these examples are taken from the House that, by design, is intended to literally spew forth legislation to later be picked apart and duly considered (and probably rejected) by the slower, sager, more above it all Senate.  Even so, I feel like I might be able to discern a pattern in the legislation habits of the 101st Congress.  380 bills from this period contain the word "mortgage."

Why the most basic search of the Congressional Record cannot be made evidence of the almost pathological obsession of the United States Congress with intervening in the mortgage market is somewhat beyond me.  How anyone can claim this environment even remotely proximate enough to "free markets" to use as leverage the current crisis in their indictment of capital markets literally tries the patience.   Also beyond me is the reason the CRA has become the condicio sine qua non of the argument.  It is beyond daft to argue, in light of these facts, that the present market ills are the sole responsibility of any given administration or any given party.  The simple fact is that in a rare, multi-decade fit of bi-partisan cohesion, Congress has been digi-copulating the mortgage market for so long and with such enthusiasm that, Plato-like, it stopped occurring to anyone to wonder if that was really such a good idea.  Be this as it may, waking up every morning to be crowned with a baseball bat, familiar as it may be, still results in a headache.

What is insidious about the entire matter, and as is typical of the most destructive legislation, the caustic cloud of mortgage assistance masks itself under the guise of righteous and "fair" redistribution goals.  It is the nature of the beast that any political animal arguing against these, no matter what the logic, will find herself lonely and out of work. be continued.

[Art Credit: Charles François Jalabeat, Antigone Leads Oedipus Out of Thebes (1849), Musée des Beaux Arts, Marseilles]

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